New Opportunities For In-Plan Roth Rollovers

by Ogletree, Deakins, Nash, Smoak & Stewart, P.C.
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In furtherance of Section 902 of the American Taxpayer Relief Act of 2012 (ATRA), the Internal Revenue Service (IRS) recently issued Notice 2013-74 updating prior IRS guidance regarding so-called “in-plan” Roth conversions under 401(k), 403(b), and 457(b) retirement plans (DC Account Plans). The Notice expands on prior IRS guidance to offer participants in many DC Account Plans more flexibility to convert vested pre-tax account balances into after-tax Roth accounts.

Background

First introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001 under section 402A of the Internal Revenue Code (Code), Roth contributions under DC Account Plans became more prevalent following the IRS’s issuance of the final section 401(k) regulations in 2006 and the enactment of legislation making Code section 402A permanent. Code section 402A gave participants in DC Account Plans the ability to designate some or all of their elective deferral contributions as Roth contributions. Unlike traditional pre-tax deferrals made under DC Account Plans, Roth contributions are made on an after-tax basis and, if certain requirements are satisfied, neither the Roth contributions nor earnings on them are subject to federal income tax when they are distributed.

While various options have been available for converting distributions from DC Account Plans into Roth “dollars” via an individual retirement account (IRA), participants in DC Account Plans with existing pre-tax account balances had fewer (or no) options to effect such conversions if they were not already eligible to receive a distribution. The Small Business Jobs Act of 2010 allowed employers to amend their DC Account Plans with existing Roth contribution features to permit participants to make “in-plan” rollovers between non-Roth and Roth accounts without having to first receive a distribution. Although this new option was attractive to many participants, it came with a substantial limit: only non-Roth amounts that were currently distributable and that qualified as an “eligible rollover distribution” were eligible for in-plan rollover. In practice, this meant that in-plan rollovers were generally only available for participants who were 59 1/2 years old or older, or who had previously terminated but not yet received payment of their non-Roth account balances. Other eligible distributions included payments due to the participant’s death or disability and qualified reservist distributions. (Revenue Ruling 2004-12 provides a more detailed discussion of this issue.)

New Rollover/Conversion Opportunities

Section 902 of ATRA modified Code section 402A to make clear that a DC Account Plan that permits Roth contributions may (but is not required to) be amended to allow participants to convert non-Roth accounts into Roth accounts. The conversion of accounts is permissible even if the non-Roth accounts are not otherwise distributable at that point, and the conversion will not trigger any tax penalties for early distribution or otherwise. This option was generally available to plan sponsors beginning on January 1, 2013.

Notice 2013-74 provides additional guidance on in-plan Roth rollovers including the following:

  • In-plan rollover opportunities are broadly available to participants in 401(k) plans, 403(b) or “tax sheltered annuity plans” sponsored by tax-exempt and governmental entities, and 457(b) plans sponsored by governmental entities. (Section 457(b) plans sponsored by tax-exempt entities are not permitted to provide for either Roth contribution or in-plan rollovers.)  In-plan rollovers may consist of pre-tax elective deferrals under section 401(k) and 403(b) plans, annual deferrals under section 457(b) plans, employer matching contributions, employer non-elective contributions, and any related earnings. Note that the plan is generally permitted to limit the types of contributions that are eligible for in-plan rollover and the frequency with which participants may avail themselves  of the rollover process. (Apparently anticipating the audience likely to be drawn to in-plan Roth rollovers—i.e., the highly compensated—the Notice reminds plan sponsors that limitations on the “benefits, rights, and features” available under DC Account Plans will remain subject to scrutiny under the Code section 401(a)(4) nondiscrimination standards.)
  • To the extent the pre-tax amounts converted through the rollover process had distribution restrictions attached to them, the rolled-over amounts will continue to be subject to those restrictions after the rollover is completed. In practice, this means that the rolled-over amounts may not be as readily distributable as “true” Roth contributions might be.
  • The Notice clarifies that the in-plan rollover process does not require withholding by the plan sponsor (nor is voluntary withholding permitted). Because the rollover process will require the participant to pay federal income tax on the amount of the rollover, the participant may need to increase his or her tax withholding or make estimated tax payments to avoid being penalized from underwithholding.
  • In welcome news, the Notice indicates that in-plan Roth rollover features are not protected by Code section 411(d)(6), meaning that they can be discontinued without great difficulty. The Notice also reminds plan sponsors that serial plan amendments to add and remove plan features may amount to impermissible discrimination under Code Section 401(a)(4) depending on which participant groups stand to benefit. For example, the brief addition of an in-plan Roth rollover feature to allow highly-paid executives to convert their pre-tax accounts to a Roth account followed by the elimination of that feature is likely to be problematic under Code section 401(a)(4) since it could well limit the ability of lower-paid participants to effect their own in-plan Roth rollovers.
  • The five-year holding period required to permit tax-free Roth distributions begins running on the first day of the participant’s tax year during which the rollover occurs.
  • The Notice also provides clarification regarding in-plan rollovers involving employer stock investments, the impact of in-plan rollovers on “top heavy” determinations, and the proper means for addressing excess deferrals after a participant has effected an in-plan rollover.

The Notice provides detailed guidance for each type of DC Account Plan regarding the timing of plan amendments to implement a rollover feature. In general, DC Account Plans may be amended immediately to permit in-plan Roth rollovers and must be amended before the first in-plan rollovers are permitted.

For section 401(k) plans, the in-plan rollover amendment is a discretionary addition, meaning an amendment to implement the feature would need to be adopted no later than the end of the plan year during which it is effective. However, the Notice extends that deadline on a temporary basis for the 2013 plan year. Under the extended deadline, a plan amendment must be adopted by the later of the last day of the plan year when it is effective or December 31, 2014. “Safe-harbor” section 401(k) plans—which are subject to limits on mid-year amendments—are subject to the same general rule, as are governmental section 457(b) plans.

Section 403(b) plans face some complexities in determining the deadline for adopting amendments to implement in-plan rollover features thanks to changes to the manner in which the IRS reviews these plans for compliance with the Code. The key takeaway from the Notice for section 403(b) plans is that the deadline for this amendment is likely to be in 2014 or later and, as with the other DC Account Plans, the amendment must be adopted before in-plan rollovers are first permitted.

Conclusion

Roth contribution features have become increasingly popular additions to DC Account Plans in recent years. The increased flexibility for in-plan Roth rollovers offered by ATRA and Notice 2013-74 will no doubt attract interest from participants desiring to prepay federal income taxes through the rollover process and wanting to shelter future investment gains from taxes when distribution of their accounts ultimately occurs.

Timothy G. Verrall is a shareholder in the Houston office of Ogletree Deakins.

- See more at: http://blog.ogletreedeakins.com/new-opportunities-for-in-plan-roth-rollovers/#sthash.QSDJdqVg.dpuf

In furtherance of Section 902 of the American Taxpayer Relief Act of 2012 (ATRA), the Internal Revenue Service (IRS) recently issued Notice 2013-74 updating prior IRS guidance regarding so-called “in-plan” Roth conversions under 401(k), 403(b), and 457(b) retirement plans (DC Account Plans). The Notice expands on prior IRS guidance to offer participants in many DC Account Plans more flexibility to convert vested pre-tax account balances into after-tax Roth accounts.

Background

First introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001 under section 402A of the Internal Revenue Code (Code), Roth contributions under DC Account Plans became more prevalent following the IRS’s issuance of the final section 401(k) regulations in 2006 and the enactment of legislation making Code section 402A permanent. Code section 402A gave participants in DC Account Plans the ability to designate some or all of their elective deferral contributions as Roth contributions. Unlike traditional pre-tax deferrals made under DC Account Plans, Roth contributions are made on an after-tax basis and, if certain requirements are satisfied, neither the Roth contributions nor earnings on them are subject to federal income tax when they are distributed.

While various options have been available for converting distributions from DC Account Plans into Roth “dollars” via an individual retirement account (IRA), participants in DC Account Plans with existing pre-tax account balances had fewer (or no) options to effect such conversions if they were not already eligible to receive a distribution. The Small Business Jobs Act of 2010 allowed employers to amend their DC Account Plans with existing Roth contribution features to permit participants to make “in-plan” rollovers between non-Roth and Roth accounts without having to first receive a distribution. Although this new option was attractive to many participants, it came with a substantial limit: only non-Roth amounts that were currently distributable and that qualified as an “eligible rollover distribution” were eligible for in-plan rollover. In practice, this meant that in-plan rollovers were generally only available for participants who were 59 1/2 years old or older, or who had previously terminated but not yet received payment of their non-Roth account balances. Other eligible distributions included payments due to the participant’s death or disability and qualified reservist distributions. (Revenue Ruling 2004-12 provides a more detailed discussion of this issue.)

New Rollover/Conversion Opportunities

Section 902 of ATRA modified Code section 402A to make clear that a DC Account Plan that permits Roth contributions may (but is not required to) be amended to allow participants to convert non-Roth accounts into Roth accounts. The conversion of accounts is permissible even if the non-Roth accounts are not otherwise distributable at that point, and the conversion will not trigger any tax penalties for early distribution or otherwise. This option was generally available to plan sponsors beginning on January 1, 2013.

Notice 2013-74 provides additional guidance on in-plan Roth rollovers including the following:

  • In-plan rollover opportunities are broadly available to participants in 401(k) plans, 403(b) or “tax sheltered annuity plans” sponsored by tax-exempt and governmental entities, and 457(b) plans sponsored by governmental entities. (Section 457(b) plans sponsored by tax-exempt entities are not permitted to provide for either Roth contribution or in-plan rollovers.)  In-plan rollovers may consist of pre-tax elective deferrals under section 401(k) and 403(b) plans, annual deferrals under section 457(b) plans, employer matching contributions, employer non-elective contributions, and any related earnings. Note that the plan is generally permitted to limit the types of contributions that are eligible for in-plan rollover and the frequency with which participants may avail themselves  of the rollover process. (Apparently anticipating the audience likely to be drawn to in-plan Roth rollovers—i.e., the highly compensated—the Notice reminds plan sponsors that limitations on the “benefits, rights, and features” available under DC Account Plans will remain subject to scrutiny under the Code section 401(a)(4) nondiscrimination standards.)
  • To the extent the pre-tax amounts converted through the rollover process had distribution restrictions attached to them, the rolled-over amounts will continue to be subject to those restrictions after the rollover is completed. In practice, this means that the rolled-over amounts may not be as readily distributable as “true” Roth contributions might be.
  • The Notice clarifies that the in-plan rollover process does not require withholding by the plan sponsor (nor is voluntary withholding permitted). Because the rollover process will require the participant to pay federal income tax on the amount of the rollover, the participant may need to increase his or her tax withholding or make estimated tax payments to avoid being penalized from underwithholding.
  • In welcome news, the Notice indicates that in-plan Roth rollover features are not protected by Code section 411(d)(6), meaning that they can be discontinued without great difficulty. The Notice also reminds plan sponsors that serial plan amendments to add and remove plan features may amount to impermissible discrimination under Code Section 401(a)(4) depending on which participant groups stand to benefit. For example, the brief addition of an in-plan Roth rollover feature to allow highly-paid executives to convert their pre-tax accounts to a Roth account followed by the elimination of that feature is likely to be problematic under Code section 401(a)(4) since it could well limit the ability of lower-paid participants to effect their own in-plan Roth rollovers.
  • The five-year holding period required to permit tax-free Roth distributions begins running on the first day of the participant’s tax year during which the rollover occurs.
  • The Notice also provides clarification regarding in-plan rollovers involving employer stock investments, the impact of in-plan rollovers on “top heavy” determinations, and the proper means for addressing excess deferrals after a participant has effected an in-plan rollover.

The Notice provides detailed guidance for each type of DC Account Plan regarding the timing of plan amendments to implement a rollover feature. In general, DC Account Plans may be amended immediately to permit in-plan Roth rollovers and must be amended before the first in-plan rollovers are permitted.

For section 401(k) plans, the in-plan rollover amendment is a discretionary addition, meaning an amendment to implement the feature would need to be adopted no later than the end of the plan year during which it is effective. However, the Notice extends that deadline on a temporary basis for the 2013 plan year. Under the extended deadline, a plan amendment must be adopted by the later of the last day of the plan year when it is effective or December 31, 2014. “Safe-harbor” section 401(k) plans—which are subject to limits on mid-year amendments—are subject to the same general rule, as are governmental section 457(b) plans.

Section 403(b) plans face some complexities in determining the deadline for adopting amendments to implement in-plan rollover features thanks to changes to the manner in which the IRS reviews these plans for compliance with the Code. The key takeaway from the Notice for section 403(b) plans is that the deadline for this amendment is likely to be in 2014 or later and, as with the other DC Account Plans, the amendment must be adopted before in-plan rollovers are first permitted.

Conclusion

Roth contribution features have become increasingly popular additions to DC Account Plans in recent years. The increased flexibility for in-plan Roth rollovers offered by ATRA and Notice 2013-74 will no doubt attract interest from participants desiring to prepay federal income taxes through the rollover process and wanting to shelter future investment gains from taxes when distribution of their accounts ultimately occurs.

Timothy G. Verrall is a shareholder in the Houston office of Ogletree Deakins.

- See more at: http://blog.ogletreedeakins.com/new-opportunities-for-in-plan-roth-rollovers/#sthash.QSDJdqVg.dpuf

In furtherance of Section 902 of the American Taxpayer Relief Act of 2012 (ATRA), the Internal Revenue Service (IRS) recently issued Notice 2013-74 updating prior IRS guidance regarding so-called “in-plan” Roth conversions under 401(k), 403(b), and 457(b) retirement plans (DC Account Plans). The Notice expands on prior IRS guidance to offer participants in many DC Account Plans more flexibility to convert vested pre-tax account balances into after-tax Roth accounts.

Background

First introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001 under section 402A of the Internal Revenue Code (Code), Roth contributions under DC Account Plans became more prevalent following the IRS’s issuance of the final section 401(k) regulations in 2006 and the enactment of legislation making Code section 402A permanent. Code section 402A gave participants in DC Account Plans the ability to designate some or all of their elective deferral contributions as Roth contributions. Unlike traditional pre-tax deferrals made under DC Account Plans, Roth contributions are made on an after-tax basis and, if certain requirements are satisfied, neither the Roth contributions nor earnings on them are subject to federal income tax when they are distributed.

While various options have been available for converting distributions from DC Account Plans into Roth “dollars” via an individual retirement account (IRA), participants in DC Account Plans with existing pre-tax account balances had fewer (or no) options to effect such conversions if they were not already eligible to receive a distribution. The Small Business Jobs Act of 2010 allowed employers to amend their DC Account Plans with existing Roth contribution features to permit participants to make “in-plan” rollovers between non-Roth and Roth accounts without having to first receive a distribution. Although this new option was attractive to many participants, it came with a substantial limit: only non-Roth amounts that were currently distributable and that qualified as an “eligible rollover distribution” were eligible for in-plan rollover. In practice, this meant that in-plan rollovers were generally only available for participants who were 59 1/2 years old or older, or who had previously terminated but not yet received payment of their non-Roth account balances. Other eligible distributions included payments due to the participant’s death or disability and qualified reservist distributions. (Revenue Ruling 2004-12 provides a more detailed discussion of this issue.)

New Rollover/Conversion Opportunities

Section 902 of ATRA modified Code section 402A to make clear that a DC Account Plan that permits Roth contributions may (but is not required to) be amended to allow participants to convert non-Roth accounts into Roth accounts. The conversion of accounts is permissible even if the non-Roth accounts are not otherwise distributable at that point, and the conversion will not trigger any tax penalties for early distribution or otherwise. This option was generally available to plan sponsors beginning on January 1, 2013.

Notice 2013-74 provides additional guidance on in-plan Roth rollovers including the following:

  • In-plan rollover opportunities are broadly available to participants in 401(k) plans, 403(b) or “tax sheltered annuity plans” sponsored by tax-exempt and governmental entities, and 457(b) plans sponsored by governmental entities. (Section 457(b) plans sponsored by tax-exempt entities are not permitted to provide for either Roth contribution or in-plan rollovers.)  In-plan rollovers may consist of pre-tax elective deferrals under section 401(k) and 403(b) plans, annual deferrals under section 457(b) plans, employer matching contributions, employer non-elective contributions, and any related earnings. Note that the plan is generally permitted to limit the types of contributions that are eligible for in-plan rollover and the frequency with which participants may avail themselves  of the rollover process. (Apparently anticipating the audience likely to be drawn to in-plan Roth rollovers—i.e., the highly compensated—the Notice reminds plan sponsors that limitations on the “benefits, rights, and features” available under DC Account Plans will remain subject to scrutiny under the Code section 401(a)(4) nondiscrimination standards.)
  • To the extent the pre-tax amounts converted through the rollover process had distribution restrictions attached to them, the rolled-over amounts will continue to be subject to those restrictions after the rollover is completed. In practice, this means that the rolled-over amounts may not be as readily distributable as “true” Roth contributions might be.
  • The Notice clarifies that the in-plan rollover process does not require withholding by the plan sponsor (nor is voluntary withholding permitted). Because the rollover process will require the participant to pay federal income tax on the amount of the rollover, the participant may need to increase his or her tax withholding or make estimated tax payments to avoid being penalized from underwithholding.
  • In welcome news, the Notice indicates that in-plan Roth rollover features are not protected by Code section 411(d)(6), meaning that they can be discontinued without great difficulty. The Notice also reminds plan sponsors that serial plan amendments to add and remove plan features may amount to impermissible discrimination under Code Section 401(a)(4) depending on which participant groups stand to benefit. For example, the brief addition of an in-plan Roth rollover feature to allow highly-paid executives to convert their pre-tax accounts to a Roth account followed by the elimination of that feature is likely to be problematic under Code section 401(a)(4) since it could well limit the ability of lower-paid participants to effect their own in-plan Roth rollovers.
  • The five-year holding period required to permit tax-free Roth distributions begins running on the first day of the participant’s tax year during which the rollover occurs.
  • The Notice also provides clarification regarding in-plan rollovers involving employer stock investments, the impact of in-plan rollovers on “top heavy” determinations, and the proper means for addressing excess deferrals after a participant has effected an in-plan rollover.

The Notice provides detailed guidance for each type of DC Account Plan regarding the timing of plan amendments to implement a rollover feature. In general, DC Account Plans may be amended immediately to permit in-plan Roth rollovers and must be amended before the first in-plan rollovers are permitted.

For section 401(k) plans, the in-plan rollover amendment is a discretionary addition, meaning an amendment to implement the feature would need to be adopted no later than the end of the plan year during which it is effective. However, the Notice extends that deadline on a temporary basis for the 2013 plan year. Under the extended deadline, a plan amendment must be adopted by the later of the last day of the plan year when it is effective or December 31, 2014. “Safe-harbor” section 401(k) plans—which are subject to limits on mid-year amendments—are subject to the same general rule, as are governmental section 457(b) plans.

Section 403(b) plans face some complexities in determining the deadline for adopting amendments to implement in-plan rollover features thanks to changes to the manner in which the IRS reviews these plans for compliance with the Code. The key takeaway from the Notice for section 403(b) plans is that the deadline for this amendment is likely to be in 2014 or later and, as with the other DC Account Plans, the amendment must be adopted before in-plan rollovers are first permitted.

Conclusion

Roth contribution features have become increasingly popular additions to DC Account Plans in recent years. The increased flexibility for in-plan Roth rollovers offered by ATRA and Notice 2013-74 will no doubt attract interest from participants desiring to prepay federal income taxes through the rollover process and wanting to shelter future investment gains from taxes when distribution of their accounts ultimately occurs.

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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