The Internal Revenue Service (IRS) issued two sets of guidance for retirement plan sponsors late this month. The first addresses the implementation and administration of “in-plan conversions” to Roth accounts, also referred to as “in-plan Roth rollovers.” The second addresses an issue that has generated increasing interest in recent years – nondiscrimination testing relief for defined benefit plans that have been closed to new participants. Although the two sets of guidance address relatively discrete topics, they provide useful rules for affected retirement plans.

In-Plan Conversion to Roth Accounts

Roth accounts are permitted to be included in 401(k), 403(b) and governmental 457(b) plans. Modeled after the rules for Roth individual retirement accounts, the Roth account rules for qualified retirement plans allow a participant to contribute after-tax dollars to a designated Roth account under a plan and receive the same tax benefits with respect to that account that are generally available with respect to Roth individual retirement accounts.

In 2010, Congress expanded these rules by amending the Internal Revenue Code (Code) to allow participants to convert distributable pre-tax benefits in the plan to a Roth account (i.e., benefits that a participant could elect to begin receiving because he had attained age 59½). In 2012, Congress further expanded the conversion right to include amounts not otherwise distributable and to expand the types of plans that can offer the conversion feature.

As a result, any vested pre-tax amounts in a plan (and associated earnings) may be converted to a designated Roth account, provided that the plan allows for such conversions and taxes are paid by the participant on the amount converted. This includes employee pre-tax contributions in 401(k) and 403(b) plans, vested employer matching and nonelective contributions and vested deferrals under governmental 457(b) plans.

In Notice 2013-74, the IRS has clarified that prior guidance regarding conversion of distributable amounts continues to be applicable under the new rules allowing for conversion of vested pre-tax amounts in the plan. The notice also provides guidance on a number of specific issues for employers that expect to allow conversions in their plans to consider. For example, the notice confirms the following:

  • the deadlines by which plans must be amended to reflect the conversion right if conversions will be permitted;
  • that employers may restrict the conversion right to only certain types of contributions (such as only employee elective deferrals, but not employer matching or nonelective contributions);
  • that plans are not required to withhold taxes in connection with conversions;
  • that the mid-year addition of a conversion program to a safe harbor 401(k) plan during 2013 or 2014 will not adversely affect the plan’s safe harbor status;
  • that a Roth conversion program is not a “section 411(d)(6) protected benefit,” and thus generally can be discontinued if the employer no longer wishes to offer conversions (subject to certain nondiscrimination issues); and
  • that a conversion that constitutes the first contribution to a designated Roth account for a participant starts the five-taxable-year period of participation requirement for determining whether distributions from the account will be qualified distributions (i.e., nontaxable).

Closed Defined Benefit Plans

A common design strategy for employers wishing to de-emphasize defined benefit plans in favor of defined contribution plans has been to close their defined benefit plans to new entrants, but to allow participants as of the date of closure to continue to accrue benefits. Typically, employees hired after the closure of the plan will participate only in a defined contribution plan.

This strategy may cause the closed defined benefit plan to experience difficulty in continuing to pass applicable nondiscrimination tests under the Code, particularly as the covered group of participants decreases in number and over time and potentially consists of a greater percentage of highly compensated employees. Of primary concern is the minimum coverage test described in Code Section 410(b). In order to pass this test, some closed plans must rely on special rules that allow the closed defined benefit to be tested on an aggregate basis with the defined contribution plans maintained by the plan sponsor. Aggregated testing is permitted only to the extent that one of three technical conditional tests can be met. Some closed defined benefit plans may not be capable of passing these conditional tests and therefore run the risk of disqualification. To address this concern, some plan sponsors find it necessary to remove some highly compensated employees from participation in the closed defined benefit plan or even to freeze all future accruals under the plan.

In Notice 2014-5, the IRS has provided special nondiscrimination testing relief through the end of the 2015 plan year for closed defined benefit plans. The purpose of the relief is to provide the Treasury Department and the IRS with time to consider the policy issues associated with various proposals to permanently modify nondiscrimination rules for closed defined benefit plans.

Under the relief, a defined benefit plan that was closed to new entrants by an amendment adopted before December 13, 2013, will not have to comply in full during either 2014 or 2015 with the special rules for aggregated plan testing if the plan meets either one of two conditions:

  • for the 2013 plan year the closed defined benefit plan met one of the conditional tests described above for aggregated defined benefit and defined contribution plan for nondiscrimination testing; or
  • the closed defined benefit plan satisfied nondiscrimination testing on a stand-alone basis in 2013.

The notice also reviews various proposals under consideration by the Treasury Department and the IRS to modify current nondiscrimination requirements for closed defined benefit plans. It is not expected that any adopted change would be effective until 2016 or thereafter.

Action Items for Plan Sponsors

Employers that sponsor plans affected by the new guidance should discuss the guidance with their advisers and consider what actions may be appropriate to take with respect to their plans.

For example, a 401(k) plan sponsor that already offers designated Roth accounts in its plan may want to weigh the relative usage of Roth accounts against the efforts necessary to administer an in-plan conversion program before steps are taken to put such a program in place. Similarly, employers sponsoring closed defined benefit plans should review recent nondiscrimination testing results and consider whether the new testing relief may be necessary or useful for insuring continuing compliance with the applicable nondiscrimination test during 2014 and 2015.