Beginning in 2010, the income limit that previously prevented taxpayers with adjusted gross income in excess of $100,000 from converting to a Roth IRA is eliminated. Also, for 2010 only, the income tax payable upon a Roth IRA conversion can be spread over two years, 2011 and 2012. Please note that elimination of the income threshold applies only with respect to Roth conversions; Roth contributions cannot be made for 2010 if the taxpayer’s adjusted gross income exceeds $177,000 for married taxpayers filing jointly or $120,000 for single taxpayers.

In addition, prior to last month the law allowed only for Roth conversions of amounts in an IRA. Individuals with 401(k) or 403(b) funds who wanted to convert them to Roth funds, within their defined contribution plan, were prohibited from doing so directly. The recently passed Small Business Jobs Act of 2010 (the Act) resolved this problem—or did it?

This advisory provides a brief explanation of the Act’s provisions, covers some key points employers should review now, and lists a few issues for which we expect future guidance from the Internal Revenue Service (IRS).

Provisions of the Act

Effective Sept. 27, 2010, the Act permits 401(k) and 403(b) plan participants to convert the pretax account balances into after-tax Roth amounts, but the Act does not permit all participants to convert their account balances to a Roth account. Rather, the account balance to be converted must be distributable under the plan.

Because a 401(k) or a 403(b) plan cannot permit in-service distributions (i.e., distributions while the plan participant is still an active employee) of salary deferral contributions prior to attainment of age 59½, only employees who have attained age 59½ can convert their 401(k) or 403(b) pretax salary deferral account balances. Participants who have terminated employment but still have 401(k) accounts can also convert. However, a plan cannot be amended solely to add a Roth conversion account (although it may be amended to allow both ongoing Roth contributions and in-plan Roth conversions).

The Act also permits governmental 457(b) plans to treat elective deferrals as Roth contributions and to allow in-plan Roth conversions. But these changes are not effective until Jan. 1, 2011, which will cause governmental 457(b) plan participants to miss the opportunity to take advantage of the special 2010 income averaging provision.

Points to review

Employers who wish to take advantage of these changes for 2010 or future years should review the following points:

  • The plan must be amended to allow for rollovers to the designated Roth accounts. The IRS is expected to provide language and guidelines for model amendments in the near future, and it is expected that employers will be allowed to amend their plans retroactively to allow for the rollovers once the IRS guidance is available.
  • The amounts to be rolled over must constitute an “eligible rollover distribution” under the terms of the plan. The plan may be amended to give plan participants more opportunities to take advantage of this rollover option by expanding the plan’s current distribution options to permit in-service distributions or distributions prior to attaining normal retirement age.
  • The plan may condition eligibility for the new distribution option on an election to roll over the amount to the Roth account.
  • Amounts transferred within the plan under this rollover option to the plan’s Roth account are subject to tax as if the amounts were rolled into a Roth IRA. For rollovers made in 2010, a taxpayer may elect to have the amounts included in his or her taxable gross income in equal parts in 2011 and 2012 or to have all amounts included as taxable gross income for 2010.
  • A 10 percent early withdrawal penalty tax will apply to any withdrawals of rollover amounts within five years after the amounts are transferred under this rollover option.
  • The plan will report any amounts rolled over from the plan’s pretax account to the Roth account on a 2010 Form 1099-R, regardless of whether the recipient elects to include the taxable portion of the rollover in 2010, or half in 2011 and half in 2012.
  • A participant who elects this rollover option cannot reverse the conversion from a pretax to a Roth account back to a pretax account.

Further IRS guidance expected

Issues on which we expect additional guidance from the IRS include the following:

  • The IRS will need to specify the period in which an amendment can be made to the plan to allow for in-plan Roth conversions in 2010.
  • IRS guidance will need to clarify the ordering rules that apply to after-tax distributions to a participant with both designated Roth contributions and in-plan conversions to a Roth account before attainment of age 59½. Roth amounts are subject to an early distribution tax if the amounts are distributed within five years of contribution or conversion. If a participant has made both Roth contributions and an in-plan conversion, an ordering rule is needed to determination whether a distribution is made from the Roth contributions or the converted amounts.
  • The IRS should confirm whether the plan is required to provide a distribution notice for in-plan conversions.