The Small Business Jobs Act (Act), signed into law on September 27, 2010, allows in-plan Roth conversions for 401(k) and 403(b) plans. Under the Act, effective immediately, plan sponsors may amend their plans to permit employees to convert their 401(k) and 403(b) pre-tax contribution accounts to Roth contribution accounts within the plan (much like conversions are now allowed from defined contribution plans to Roth IRAs). The Act also provides that, effective January 1, 2011, Roth salary deferrals and in-plan conversions may be included under governmental 457(b) plans.
In-plan Roth conversions may be offered only under a plan that allows Roth salary deferrals to be made under the plan. Plans may not offer designated Roth accounts solely to accept these conversions. Accordingly, a profit-sharing plan without a salary deferral arrangement, or any other defined contribution plan without a Roth salary deferral arrangement, cannot allow in-plan Roth conversions.
Amounts Eligible for In-Plan Roth Conversions. Only amounts otherwise eligible for distribution from a defined contribution plan may be converted or rolled over to a Roth account within the plan.
- If an employer’s 401(k) or 403(b) plan already permits in-service distributions of pre-tax salary deferrals at age 59-½, or upon disability, the plan may be amended to allow employees to convert their pre-tax salary deferral contribution accounts to Roth accounts when they would otherwise be eligible to take an in-service distribution.
- If an employer’s 401(k) or 403(b) plan permits in-service distributions from employer contribution accounts (such as matching and employer discretionary contribution accounts), the plan may be amended to allow employees to convert these accounts to Roth accounts when the plan’s in-service distribution requirements are satisfied. Because of the less restrictive distribution rules for employer contributions, for some plans, this would mean generally that employees could convert employer contribution accounts to Roth accounts when such contributions have been in the plan for at least two years, or when the employee has been a participant in the plan for at least five years.
- If an employer’s 401(k) or 403(b) plan does not already permit the full range of in-service distributions, the employer should consider whether to expand distribution options under the plan, to allow employees to take full advantage of in-plan Roth conversions.
Note that the joint committee report of the Act provides that a plan may condition eligibility for a new distribution option on an employee’s election to have the distribution directly rolled over to the designated Roth program within that plan. By doing so, the plan would prevent the leakage of plan assets but otherwise would provide employees the option to convert their pre-tax contributions to Roth contributions.
Taxation of Roth Conversions. A participant will be subject to tax on all pre-tax contributions rolled over to a Roth account. The rolled over amount will not be subject to the additional 10 percent early withdrawal penalty, however. For 2010 rollovers only, participants may choose to use the special delayed reporting rules and include in income half of the taxable amount of the rollover in 2011 and half in 2012. In the absence of IRS guidance, it appears that as a direct rollover, no amounts would be withheld from the funds rolled over, so participants would be required to pay taxes with funds outside their plan account.
Plan Amendments. Generally, plan amendments that add discretionary features must be adopted by the last day of the plan year. The legislative history of the Act indicates that the IRS will provide a remedial amendment period allowing employers to amend their plans after 2010 to reflect the in-plan Roth conversion option, even if implemented in 2010. It is not clear, however, whether the remedial amendment period also will apply to all related amendments, such as an amendment to permit Roth elective deferrals under the plan.
Effective Date. 401(k) and 403(b) plans may add the in-plan Roth conversion feature to be effective on or after September 27, 2010. Governmental 457(b) plans may permit Roth elective deferrals, and the in-plan Roth conversion feature, on and after January 1, 2011.