In December of 2013, the IRS issued Notice 2013-74, which provides plan sponsors with guidance on how plan participants can elect an in-plan Roth conversion of pre-tax amounts not yet eligible for distribution from the plan.

Notice 2013-74 confirms that plan sponsors that implement an in-plan Roth conversion option generally may limit the types of vested contributions that participants can convert, may specify the frequency with which participants can elect to make in-plan conversion elections, and may discontinue the in-plan conversion right. The IRS notice also sets forth time frames during which plan sponsors may adopt amendments related to an in-plan Roth conversion feature, and provides other guidance regarding in-plan Roth conversions of both distributable and nondistributable amounts. These rules are described below.

What is an in-plan Roth conversion?

A 401(k) plan, a 403(b) plan, and a governmental 457(b) plan may offer participants the election to make in-plan Roth conversions (referred to as “in-plan Roth rollovers” in the IRS Notice), which results in the transfer of assets from the participant’s non-Roth accounts to a designated Roth account in the same plan. An in-plan Roth conversion results in the converted amounts being taxed in the year of the conversion, while generally allowing for future distributions of converted amounts and any accumulated earnings to be made tax-free, so long as the account has been in place for at least five years and the distribution satisfies certain restrictions.

What amounts can be converted to Roth after-tax amounts?

All vested accounts in an eligible plan may be converted under an in-plan Roth conversion feature, including employee pre-tax elective deferrals, employer matching contributions, and employer nonelective (profit-sharing) contributions, as well as earnings on those contributions. Only vested amounts may be converted. The amounts eligible for conversion do not have to be eligible for a distribution in order to be converted, as was the case under prior law.

Can the plan sponsor impose any restrictions on the in-plan Roth conversion?

The IRS Notice states that plan sponsors may restrict the types of vested contributions eligible for an in-plan Roth conversion and the frequency with which participants can make in-plan Roth conversions, provided that those restrictions do not result in discrimination in favor of highly compensated employees. This will be helpful for plan sponsors who do not want to deal with participants electing in-plan Roth conversions throughout the year, as the plan could provide that such conversions are permitted only once per year or only in December.

The Notice also states that the right to make an in-plan Roth conversion is not a protected benefit and thus in-plan Roth conversions can be discontinued by the plan sponsor.

What do plan sponsors need to know about the administration of in-plan Roth conversions?

No withholding on in-plan Roth conversions
Amounts converted under an in-plan Roth conversion option are not subject to income tax withholding, although those amounts will be taxable to the participant in the year of the conversion. As a result, participants who elect an in-plan Roth conversion may need to increase their withholding rates or make estimated tax payments to cover their income tax liability resulting from the conversion.

Distribution restrictions for converted amounts
The Notice states that any distribution restrictions that applied to an amount before it is converted to a Roth after-tax amount under an in-plan Roth conversion will continue to apply to the converted amount. This will require that the converted amounts be accounted for separately in the plan, in order to preserve any such distribution restrictions.

Calculation of five-year period for qualified Roth distributions
Distributions of Roth amounts and accumulated earnings generally are tax free if they are qualified distributions (paid upon death, disability or attainment of age 59-1/2) from a Roth account made more than five taxable years after the first year the participant contributed to the Roth account. For the purpose of determining when a subsequent distribution is qualified, the IRS Notice states that, if an in-plan Roth conversion is a participant’s first contribution to a designated Roth account in the plan, the five-taxable-year period begins on the first day of the taxable year in which the in-plan Roth conversion was made. So, for an initial in-plan Roth conversion occurring in July of 2014, the five-taxable-year period will begin on January 1, 2014.

Nondiscrimination testing – top heavy treatment and treatment of excess contributions
The Notice states that an amount converted in an in-plan Roth conversion is treated as a “related rollover” amount that is considered in calculating participant account balances in determining the plan’s top heavy status.

The Notice also states that, if amounts converted under an in-plan Roth conversion feature are later found to be excess deferrals or excess contributions under applicable nondiscrimination rules, those excess amounts must be distributed from the Roth account even if the amounts were considered otherwise nondistributable at the time of the in-plan Roth conversion.

When must a plan sponsor adopt the amendment adding the in-plan Roth conversion option to the plan?

Under Notice 2013-74, a 401(k) plan or governmental 457(b) plan generally can immediately begin offering in-plan Roth conversions (even if they did not allow Roth contributions or accept Roth rollover contributions previously), so long as the plan amendment permitting in-plan Roth conversions is adopted by the later of (a) the last day of the plan year in which the amendment is effective, or (b) December 31, 2014. The Notice also permits sponsors of a safe harbor 401(k) plans to begin immediately offering such conversions in 2014, even in the middle of 2014. However, beginning with the 2015 plan year and for all future plan years, that amendment to a safe harbor 401(k) plan would have to be adopted in advance of the plan year.

A 403(b) plan sponsor that has timely adopted a written plan document may offer in-plan Roth conversions immediately as well and must adopt an amendment by the later of the last day of the first plan year in which the amendment is effective, or the end of the ongoing remedial amendment period (when the IRS announces the remedial amendment period for 403(b) plans). The Notice indicates that the IRS expects the end of the 403(b) plan remedial amendment period to be at least one year after the date that the IRS announces the remedial amendment period.

What are the next steps plan sponsors should take?

By expanding the plan accounts that are eligible for an in-plan Roth conversion, the new rules provide participants with a greater opportunity to convert pre-tax dollars to Roth after-tax dollars. In-plan Roth conversions are especially attractive for individuals currently in lower tax brackets who have assets outside of the plan that can be used to pay the taxes incurred due to the conversion.

Plan sponsors may, but are not required to, amend their eligible plans to add or expand the in-plan Roth conversion feature. A plan is not required to offer the expanded in-plan Roth conversion option simply because the plan already offers an in-plan Roth conversion feature permitted under the prior rules or accepts ongoing Roth contributions.