On March 5, 2008, the Internal Revenue Service (the IRS) issued Notice 2008-30 (the “Notice”), which addresses three distinct distribution-related provisions under the Pension Protection Act of 2006 (PPA) and final Regulations of the US Department of the Treasury under Sections 401(k) and 402(g) of the Internal Revenue Code of 1986, as amended (the “Code”), along with certain other highly technical provisions which are beyond the scope of this article. Generally, the Notice: (i) provides guidance on rollovers from eligible retirement plans to Roth IRAs—including, significantly, the elimination, effective for taxable years beginning on and after January 1, 2010, of the modified adjusted gross income (M-AGI) limit with respect to conversions of non-Roth IRAs to Roth IRAs; (ii) addresses concerns with respect to amending plans to require that distribution of excess deferrals include earnings from the end of the taxable year to the date of distribution (“gap-period” earnings); and (iii) adds an additional survivor annuity requirement for defined benefit and money purchase plans. In one particular case, as discussed below, the economic effect of the changes may be quite substantial.
Section 824 of PPA (Qualified Rollover Contributions to Roth IRAs)
Prior to amendment by PPA, a Roth IRA could only accept a rollover contribution of amounts distributed from (i) another Roth IRA, (ii) a non-Roth IRA (i.e., a traditional or so-called “SIMPLE” IRA) or (iii) a designated Roth account described in Section 402A of the Code. Rollover contributions to Roth IRAs are called “qualified rollover contributions.” A qualified rollover contribution from a non-Roth IRA to a Roth IRA is known as a “conversion,” and is subject to certain rules.
The Notice addresses Section 824 of PPA which provides that, beginning in 2008, distributions from an eligible retirement plan may be rolled over to a Roth IRA, provided that all of the following conditions are satisfied: (i) the amount rolled over is an “eligible rollover distribution”1; (ii) the employee who rolls over an amount from a non-Roth IRA to a Roth IRA includes in his or her gross income any portion of the conversion amount that would be includible in gross income if the amount were distributed without being rolled over; and (iii) for taxable years beginning before January 1, 2010, an employee cannot make a qualified rollover contribution from an eligible retirement plan other than a Roth IRA if, for the year the eligible rollover distribution is made, he or she has M-AGI exceeding US$100,000, or is married and files a separate return.
The Notice also clarifies that if a taxable amount is rolled over into a Roth IRA from an eligible retirement plan, other than a Roth IRA, and, is distributed within five years, the ten percent additional tax under section 72(t) of the Code would apply.
Importantly, the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), passed on May 17, 2006, eliminates the M-AGI income cap for conversions, effective for taxable years beginning on and after January 1, 20102.
Tax-Planning Opportunity: Contributions to a Roth IRA are not tax-deductible when made (i.e., they are made on an after-tax basis); however, earnings grow tax-free and, assuming certain requirements are met, qualified distributions are non-taxable. As a result, the time value of money, eventually distributed with no tax burden whatsoever, can work greatly in favor of those individuals who open or convert to Roth IRAs and let them grow over a number of years, or even decades, particularly in the case of successful equity and other speculative investments.
Initially, Roth IRAs were not available to a taxpayer unless specified M-AGI levels were not exceeded. This restriction showed Congress’ concern regarding the significant benefit of the Roth approach, and relatively higher-income taxpayers were not allowed to have Roth IRAs.
With the addition of Roth 401(k) contributions, Congress began to move away from denying access to the Roth approach, and there are no income restrictions on the ability to have a Roth 401(k) account. TIPRA conforms, the basic Roth IRA conversion provisions to the Roth 401(k) approach, eliminating the M-AGI restrictions.
By opening up this valuable tax break to individuals whose income levels previously prohibited them from taking advantage of Roth IRA conversions, one can assume that, absent corrective action, federal tax revenues can be expected to fall off dramatically in future years; therefore, it might make sense to avail oneself of this tax break early—as soon as the “window” period opens—and, in the meantime, to plan one’s finances accordingly.
If that sounds too good to be true, consider the downside: conversions from non-Roth amounts to Roth IRAs are generally taxable for the year in which the conversions were made. As an example, suppose you have a 401(k) balance of US$100,000, consisting of pre-tax contributions and earnings thereon. Under the general rules, you would incur US$100,000 of taxable income for 2010. However, under TIPRA, for the 2010 year only, if you convert your 401(k) balance to a Roth IRA in 2010, unless you elect otherwise, US$50,000 of the income resulting from the conversion is included in income in 2011, and US$50,000 is included in income in 2012 (i.e., you incur no taxation in 2010).
Obviously, when considering whether to convert a non-Roth amount (including an amount from a 401(k) plan) to a Roth IRA, you must consider the tax consequences of such action, and no tax advice whatsoever is provided here. We strongly advise you to consult with your own professional tax advisor with respect to conversions from 401(k) plan accounts to Roth IRAs.
In addition, the Notice indicates that the rollover may be made in a direct rollover from the plan to the Roth IRA, or the amount may be distributed from the plan and rolled over by the employee to the Roth IRA within 60 days. The 20 percent withholding rules would apply, however, if a rollover is paid directly to the employee and not directly rolled over to the Roth IRA.
Section 402(g)(2) “Gap Period” Earnings
Effective for taxable years beginning on or after January 1, 2007, final US Department of Treasury regulations under Section 402(g) of the Code provide that interest must be included with distributions of excess deferrals,3 to the extent the employee is or would be credited with an allocable gain or loss on the excess deferral during the period from the end of the plan year in which the excess deferral occurs until the actual distribution date (the “Gap Period”). The Gap Period earnings apply to both pre-tax excess deferrals and excess deferrals that are designated Roth contributions.
The Notice indicates that individually designed plans that must be submitted for the Economic Growth and Tax Relief Reconciliation Act of 2006 (commonly referred to as “EGTRRA”) determination letters cycle C (ending January 31, 2009) are required to provide for the distribution of Gap-Period earnings. Notably, a plan submitted for a determination letter before March 24, 2008 that does not provide for the distribution of Gap-Period earning will be asked by the IRS to amend the plan to include the distribution of Gap-Period earnings prior to the receipt of the determination letter.
Section 1004 (Survivor Annuity Options)
Defined benefit and money purchase plans that provide for a qualified joint and survivor annuity (QJSA) must provide that accrued benefits be payable, in the case of a vested participant who does not die before the annuity starting date, in the form of a QJSA, unless the participant and his or her spouse consents to another form of benefit. A QJSA is a joint and survivor annuity with a continuation of benefits to a surviving spouse of at least 50 percent, but not more than 100 percent continuing to the spouse upon the participant’s death. Plans subject to the QJSA rules must provide a written explanation of the terms and conditions of the QJSA to each participant as described and within the time frame specified under the QJSA rules.
The Notice also addresses Section 1004 of PPA which requires plans subject to the QJSA rules to also offer to participants who waive the QJSA an opportunity to elect a survivor annuity option called a “qualified optional survivor annuity” (QOSA). A QOSA is an annuity for the life of a participant with a survivor annuity for the life of the participant’s spouse that is equal to a specified applicable percentage of the amount of the annuity that is payable during the joint lives of the participant and the spouse.
If the continuing percentage under a plan’s QJSA is less than 75 percent, the QOSA must provide a 75 percent continuing percentage. If the plan’s QJSA provides a continuing percentage of at least 75 percent, the QOSA must provide a 50 percent continuing percentage.
If the QOSA is not actuarially equivalent to the QJSA, spousal consent would be required for the participant to waive the QJSA and elect the QOSA. If the QOSA is actuarially equivalent to the QJSA, spousal consent would not be required.
The Notice provides some welcome guidance with respect to three distinct issues under PPA and the final regulations under Code sections 401(k) and 402(g). Further, TIPRA’s repeal of the M-AGI limits for conversions to Roth IRAs on and after January 1, 2010 creates unique tax planning opportunities, especially with respect to 2010 taxable years.
As always, White & Case would be happy to advise you with respect to the impact that the Notice may have on your plans, or as to the tax advantages and implications of making rollovers to Roth IRAs.