Two Strategies for Enhancing Roth Conversion Opportunities

Roth conversions have become a popular tax planning tool in 2010, especially in light of the uncertainty surrounding future tax rates. This EB Insider describes two strategies for 401(k) plan sponsors to offer enhanced Roth conversion opportunities to participants and beneficiaries. The first is Roth in-plan conversions, which became available last week through the Small Business Jobs Act of 2010. The second is liberalizing plan distribution provisions for current employees who elect Roth IRA conversions, a technique the IRS has approved in an earlier letter ruling.

Employers who choose to adopt either strategy will need to act quickly, to enable participants and beneficiaries to elect Roth conversions before year-end. The decision to elect a Roth conversion is a complicated one which will depend on many factors specific to each individual. As such, employers should tailor their communications carefully to avoid providing tax advice to participants, or suggesting any particular course of action.

Roth IRA Conversions Generally

In 2010, assets in a qualified plan or traditional IRA may be converted to a Roth IRA, without regard to the income limits that applied in the past. Moreover, the amount converted is subject to income tax in 2011 and 2012 (50% each year), unless the individual elects to pay the taxes in 2010. The conversion also may be revoked on or before October 15, 2011.

Individuals who are concerned about 2011 tax increases may elect a Roth conversion to lock in the ability to pay taxes using 2010 rates. If tax rates do not increase, the individual may spread the tax hit over 2011 and 2012. If the individual’s account balance decreases, the individual may revoke the conversion completely, to avoid paying taxes on non-existent assets.

For qualified plans, the Roth IRA rollover option applies only to amounts which may be distributed from the plan. For example, pre-tax 401(k) contributions may be converted only by participants who have reached age 59½ or separated from service.

Strategy # 1 – Roth In-Plan Conversions

Plan sponsors now may amend their plans to allow Roth in-plan conversions. In other words, participants and beneficiaries could elect to convert non-Roth contributions to Roth contribution accounts within the plan, instead of moving the assets to a Roth IRA.

In-plan conversions provide the same basic benefits as Roth IRA conversions but enable participants to keep their money in their employer’s plan, avoiding the need to find a separate Roth IRA provider and pay potentially higher administrative fees. In-plan conversions may appeal to employers who prefer to hold assets in the plan for as long as possible, to protect employees’ retirement savings or to avoid higher per participant fees for record-keeping and investment services. The legislation also permits plan sponsors to offer liberalized distribution rights which apply only in the context of in-plan conversions, enabling participants and beneficiaries to move more funds into their Roth accounts, but prohibiting them from removing these funds from the plan. Liberalized distribution rights are described in more detail below.

In order to offer in-plan conversions, a plan must offer a Roth 401(k) contribution option, so plans which do not already permit Roth 401(k) contributions would need to do so before year-end. The IRS has not yet outlined the specific steps plan sponsors and individual taxpayers will need to take (e.g., plan amendments, operational changes, etc.) to effectuate in-plan conversions before year-end. It is also unclear whether in-plan conversions may be revoked in 2011, making the Roth IRA conversion a more attractive option for individuals who wish to preserve maximum tax flexibility.

Strategy # 2 – Enhanced Roth IRA Conversions

Even without adding an in-plan Roth conversion feature, employers may amend their plans’ distribution rules to facilitate Roth IRA conversions. Although pre-tax contributions generally may not be withdrawn until the participant reaches age 59 ½ or separates from service, after-tax and rollover contributions may be distributed at any time – many plans already provide this option. Matching and other employer contributions also may be withdrawn sooner, as long as they are not taken into account for purposes of certain non-discrimination requirements. Employer contributions are eligible for withdrawal if the individual has been a plan participant for at least five years or the contributions have been in the plan for at least two years.

The IRS held in a prior letter ruling (PLR 8037032) that the amendment may limit the liberalized distribution rights to contributions which are rolled over to an IRA. This would facilitate Roth IRA conversions but would not permit participants to take direct distributions from the plan (although they would be able to take distributions from the IRA following the rollover).

Liberalizing plan distribution provisions to facilitate Roth conversions offers all the advantages of Roth IRA conversions but limits the administrative burden for the plan sponsor and record-keeper by moving assets out of the plan. Roth IRA conversions also are revocable until October 15, 2011. However, plans will need to be amended before year-end to reflect the more liberal distribution rights, and employers and participants who prefer to keep assets in the plan will prefer the in-plan conversion feature.

Feel free to contact the Ivins employee benefits team to discuss either one of these options.