Fiscal Cliff Legislation Provides New In-Plan Roth Conversion Opportunity

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The newly enacted American Taxpayer Relief Act (H.R. 8) includes a significant new opportunity to perform “in-plan” conversions of pretax dollars to Roth (after-tax) dollars of funds held in defined contribution retirement plans (such as Section 401(k) plans, Section 403(b) plans, and governmental 457(b) plans). President Obama signed the legislation on January 2, 2013.

Plan sponsors who previously considered but rejected implementing an in-plan Roth conversion feature for their plans due to the modest benefit previously available to employees may now want to reconsider whether such an approach makes sense in light of the greater benefits provided under the new law.

For plan years beginning after December 31, 2012, employers will have the option, but not the obligation, to amend their defined contribution retirement plans to add (or expand) the new conversion feature. An in-plan Roth conversion of pretax (non-Roth) plan assets causes the converted amounts to become taxable in the year of the conversion, but allows any future qualified distributions of the converted amounts, along with any accumulated earnings, to be provided tax-free to the participant.

Prior to the passage of the Act, in-plan Roth conversions were available on a more limited basis. Such conversions were only permitted for amounts that participants were otherwise eligible to withdraw. In general, this meant that the amounts eligible for conversion were limited to funds the participant had rolled over from a prior plan and/or amounts the participant could withdraw upon reaching age 59 ½. This resulted in a relatively small pool of potential participants and assets that were eligible for the in-plan Roth conversion.

Under the new, expanded conversion right, an eligible plan that permits regular non-rollover Roth contributions could allow participants to convert any pre-tax vested amounts to Roth amounts within the plan – whether or not participants are eligible to withdraw such amounts. By broadening the potential assets eligible for conversion to include previously ineligible amounts, such as employee elective deferrals and employer matching contributions, the new law provides participants with a much higher potential base from which they can choose to convert to after-tax dollars.

Additional guidance will be needed to confirm how the expanded conversion right will be carried out. It is likely that the new conversion right will operate in the same manner as existing in-plan Roth conversions under IRS Notice 2010-84, but this has not been confirmed by the IRS.

If you have questions regarding the new Roth conversion opportunity provided by the American Taxpayer Relief Act and how it may affect your retirement plan, please feel free to contact Brian M. Pinheiro at 215.864.8511 or pinheiro@ballardspahr.com, Josh Bobrin at 215.864.8409 or bobrinj@ballardspahr.com, or any member of Ballard Spahr’s Employee Benefits and Executive Compensation Group.

Topics:  401k, American Taxpayer Relief Act, Employee Benefits, Fiscal Cliff, IRA, IRS, Retirement, Retirement Plan, Roth Conversions

Published In: Tax Updates, Wills, Trusts, & Estate Planning Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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