Modification of Roth In-Plan Conversion Rules Provides Participants Greater Flexibility


Tucked in the provisions of the year-end financial cliff legislation (the "American Taxpayer Relief Act of 2012") was a provision which creates greater flexibility in the conversion of qualified plan dollars to tax-free status through in-plan Roth conversions.


Under prior law, a retirement plan, such as a 401(k) plan, a 403(b) annuity plan or a 457 governmental plan, that had a Roth elective deferral feature could allow a participant to roll over his non-Roth account plan balances into a Roth account under the plan (through a so-called "in-plan Roth conversion"). The amount rolled over to the Roth account would become taxable income to the participant at the time of the rollover. Thereafter, the rolled over amount plus all further appreciation would be exempt from tax, assuming compliance with the normal Roth-qualified distribution requirements (i.e., distribution after age 59-1/2, disability or death and distribution made more than five years after the Roth account is established). An in-plan Roth conversion can be an effective tool for a participant to manage the risk of future tax rate increases.

However, under prior law, in order to roll over an amount as an in-plan Roth conversion, that amount had to be otherwise eligible for a distribution from the plan. For example, amounts contributed by an employee through a 401(k) cash or deferred arrangement generally could not be rolled over into the Roth account through an in-plan Roth conversion before the earlier of the employee's severance from employment or attainment of age 59-1/2 (because 401(k) cash or deferred amounts may not be distributed prior to attainment of age 59-1/2, severance from employment or certain other events). This distribution requirement generally limited the opportunity for in-plan Roth conversions to older participants.

Effect of Change

The American Taxpayer Relief Act of 2012 relaxed the rules for in-plan Roth conversions by providing that a plan may permit a participant to transfer an amount into the plan's designated Roth account even if the amount is not otherwise distributable under the plan. This change provides added flexibility, not only for 401(k) plans, but also for 403(b) tax-deferred annuity plans, 457(b) deferred compensation plans and other plans which have restrictions on in-service distributions. Younger employees who are taxed at comparatively lower effective tax rates and with longer investment horizons may now find the in-plan Roth conversion to be an attractive tax and retirement planning strategy under this new, relaxed rule.

Plan Must Be Amended to Permit Conversion

Employers who wish to make available the new in-plan Roth conversion opportunity to plan participants will need to amend their plans to specifically authorize in-plan Roth conversions. In-plan Roth conversions are permissible only if the plan also permits regular designated Roth contributions to be made. Furthermore, any distribution restrictions which were applicable prior to the in-plan Roth conversion must continue to apply after the conversion. For example, 401(k) salary deferral contributions which are ineligible for pre-age-59-1/2 in-service distributions (except in the case of a "hardship") will continue to be subject to those restrictions on distributions following the in-plan Roth conversion.

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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