The Small Business Jobs Act of 2010 (the “Act”), signed into law on September 27, 2010, permits pre-tax accounts in certain cases to be converted to Roth (after-tax) accounts within a retirement plan. This applies to 401(k) and 403(b) plans now and, beginning in 2011, to 457(b) retirement plans. Employers must soon decide whether they want to amend their plans to allow for the conversion.
Employers who sponsor 401(k) and 403(b) plans may design their plans so that participants can elect to make Roth deferrals. Roth deferrals are after-tax contributions, but qualified distributions from Roth accounts are tax-free. Significantly, all of the earnings compounded on the Roth deferrals are not taxable. Because of the tax benefits, Roth accounts have gained wide popularity since their enactment.
Before the Act was passed, if a participant wanted to roll over his pre-tax deferrals into a Roth account, the only way to do so was to roll over his accounts into a Roth IRA. At that time, the rollover amount would become taxable income to the participant (with the understanding that the qualified distribution from the Roth IRA would be tax-free). A special rule allows rollovers occurring in 2010 to be taxed over two years (50% of the rollover included in income in 2011 and 50% of the rollover included in income in 2012) rather than the entire amount being taxable in 2010. However, participants may choose to include these amounts in income in 2010.
Sponsors of 401(k) and 403(b) plans (and, beginning in 2011, governmental 457(b) plans) can now amend their plans to allow intra-plan conversions of pre-tax elective deferrals into Roth elective deferrals. Participants in a plan that allows Roth contributions can transfer their pre-tax deferrals into their plan’s Roth accounts if the pre-tax deferrals are otherwise eligible for distribution. These intra-plan conversions allow participants to keep their elective deferrals in their plans without having to roll over to Roth IRAs.
The requirement that pre-tax deferrals be otherwise eligible for distribution severely limits the participants who may choose to make an intra-plan conversion. Generally, younger participants tend to benefit most from Roth accounts (since they have the longest earnings period before the accounts are distributed); however, they are also the least likely individuals to have a distributable event that would allow an intra-plan conversion. Nevertheless, older participants who have reached age 59 ½ may, if the plan permits, want to take a distribution to convert their pre-tax account to a Roth account in their plan.
There are tax incentives to making an intra-plan conversion this year (by December 31, 2010). As mentioned above, pre-tax amounts that are converted in 2010 may be recognized as taxable income ratably in 2011 and 2012. A plan amendment will be necessary to add this intra-plan conversion feature. If an employer’s plan does not already allow Roth deferrals, the plan can be amended to permit Roth deferrals and, at the same time, to allow intra-plan conversions.
Representatives from the Department of the Treasury have informally requested that plan sponsors wait until further guidance before amending their plans. Further guidance regarding plan amendment and administration issues is expected.
Governmental 457(b) Plans
The Act permits 457(b) plans sponsored by state or federal governments to allow Roth deferrals beginning January 1, 2011. Governmental 457(b) plan sponsors will have to amend their plans to add this feature. Governmental 457(b) plans that include Roth deferrals may also be amended to allow intra-plan conversions of pre-tax deferrals into Roth accounts beginning January 1, 2011.