On Monday, September 27, 2010, President Obama signed the Small Business Jobs Act of 2010 (the Act). Among various other tax provisions, the Act has two new rules for employee retirement plans.
Section 2112 of the Act provides a new option in connection with Roth conversions. Previously, a participant could not "convert" qualified plan funds into a Roth account within the same plan (or any other employer-sponsored plan). Rather, a rollover was required to be made to a Roth IRA.
The Act allows the employer plan to accept conversions within the plan itself as long as the plan accepts Roth contributions as an alternative to traditional elective deferrals under either a 401(k) plan or 403(b) plan. Only funds that would otherwise be eligible for an immediate distribution could be converted, such as (i) any portion of the account for a terminated participant, (ii) any portion of the account for an active participant over age 59 1/2, or (iii) the non-401(k) or 403(b) portion of the account for an active participant under age 59 1/2 that is not otherwise required to be held in the plan. An amendment would be necessary to allow the new conversion option.
Consistent with the special rules for a 2010 conversion to a Roth IRA, if elected by the participant, the income tax recognition of the conversion would be deferred, including one-half of such income in 2011 and the second half in 2012. Likewise, the distribution would be exempt from the 10 percent early distribution rule for the participants under age 59 1/2 as long as there was no distribution from the Roth account for at least five years.
Whether or not a Roth conversion is appropriate for any given taxpayer is a complicated question. It can involve many factors, such as the current tax rates compared to anticipated tax rates in future years, the use of the special 2010 alternative to defer recognition of taxable income into 2011 and 2012, the amount of future account investment returns, the timing of future withdrawals, the impact on future taxable income levels as they relate to phase-out rules (e.g., restrictions on deduction limits based on high income levels), the availability of after-tax funds to pay the tax triggered by the conversion, and the applicability of state and local income tax. A discussion of these issues is beyond the scope of this alert.
The Act does not affect an eligible taxpayer's rights to convert except with respect to the vehicle in which the converted funds can be held, i.e., under the employer plan rather than a separate Roth IRA. In fact, there are several potential disadvantages for the taxpayer with respect to a conversion within the employer plan rather than into a Roth IRA, including:
- In a Roth IRA, the required minimum distribution rules generally applicable to employer plans and IRAs do not apply. That is, no distribution is required from the Roth IRA once the taxpayer attains age 70 1/2. The same is not true for Roth accounts within an employer retirement plan.
- For conversions to a Roth IRA, the taxpayer has the ability to revoke the conversion until the end of the income tax filing period for the year of the conversion. For example, if the conversion to the Roth IRA occurred in 2010, the taxpayer could revoke the conversion as late as October 15, 2011 (if not later given the special delayed tax treatment available for 2010 conversions). The Act does not mention any ability to revoke an election to convert to a Roth account within an employer plan.
- If a nonqualified distribution is made from a Roth IRA and the taxpayer is at least age 59 1/2, the assumption for tax purposes is that there is first a nontaxable return of basis. The same convention does not apply for nonqualified distributions from an employer plan, for which the assumption is a pro rata distribution of pre-tax and after-tax amounts.
Section 2111 allows governmental 457(b) plans to offer a Roth contribution option effective in 2011. Currently, governmental plans under Internal Revenue Code Section 457(b) have been permitted to offer 401(k) deferrals but not a Roth alternative. Starting in 2011, a governmental plan permitting Roth contributions would also be permitted to allow conversions as described above.