On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010. The Act provides a variety of tax incentives aimed at small businesses. To help pay for these tax breaks, the Act also permits a special conversion opportunity that a company can offer under its 401(k) or 403(b) plan, but only if the plan also provides for regular Roth contributions.
As a reminder, a Roth contribution feature permits an employee to make contributions on an after-tax basis to a separate designated account under the plan, subject to the annual IRS limits for pre-tax contributions. However, unlike the earnings on pre-tax contributions which grow on a tax deferred basis but are ultimately taxed upon their distribution, the earnings on Roth contributions can grow tax-free.
Under the Act, an employee can elect to convert some, or all, of certain pre-tax amounts into Roth after-tax amounts inside the plan, provided that such amounts would otherwise be distributable as an eligible rollover distribution under IRS rules and plan terms. For example, if the plan so provides, amounts under 401(k) and 403(b) plans could be distributable if the employee has attained age 59½ or the amounts have been held in the plan for a specified period.
The converted amount will result in taxable income to the employee, but the 10% penalty tax for early distributions will not apply. As an additional incentive, for conversions during the remainder of 2010, the taxable income can be recognized over the 2011 and 2012 tax years, unless the employee elects less generous tax treatment. Thus, the new conversion rules should provide employees with a tax planning opportunity and encourage them to keep distributable amounts in the company’s plan. Unlike a Roth IRA conversion, however, the employee would not have the option of recharacterizing the “in-plan” conversion back into pre-tax contributions if, for example, a market downturn were to occur following the conversion.
As noted above, these conversions are permitted only if the plan also permits Roth contributions. However, even if the company’s plan does not currently provide for a Roth contribution feature, the plan could be amended to provide for this feature coincident with allowing the special in-plan conversions under the Act.
These rules can apply to 401(k) plans and 403(b) plans effective September 27, 2010. If your company wishes to consider offering the special Roth in-plan conversions under its 401(k), 403(b), or governmental 457(b) plan, we recommend discussing timing and next steps with your employee benefits counsel or third-party administrator.