The Small Business Jobs and Credit Act of 2010 ("Jobs Act") changed Roth rollover rules to permit a 401(k) or 403(b) plan to allow a participant who is otherwise eligible to make a rollover to move a pre-tax account distribution to a Roth rollover account within the same plan. If this in-plan rollover occurs in 2010, the participant can elect to have the rollover taxed half in 2010 and half in 2011. After that, rollovers are taxed in the year the rollover to the Roth occurs.
Why is this attractive?
Moving pre-tax money to a Roth account results in immediate taxation of the amount rolled over but allows the earnings on that amount to be tax-sheltered. When the individual uses Roth account money in the future, it is not taxed. If the individual believes that tax rates in the future will be higher than current tax rates, a Roth account may be attractive.
Why would an employer with a 401(k) or 403(b) plan add this feature?
We are not sure why.
First, the in-plan Roth conversion can only be added to a plan that already offers Roth contributions. A plan cannot set up its Roth accounts solely for the purpose of allowing in-plan Roth conversions.
Second, conversions are allowed only when there is a "distributable event" which in most instances means upon a termination of employment. Thus, conversions are generally for former employees and allows them to keep their money in the plan. Many employers do not encourage former employees to stay in the 401(k) or 403(b) plan.
Roth rollovers to Roth IRAs and other plans that accept Roth rollovers are already in place. Conversions can already occur when money leaves the plan. In-plan Roth conversions allow participants to increase savings that are designated "Roth" and stay in the plan.
Many plan recordkeepers are struggling to set up new systems, forms and procedures to accommodate in-plan Roth conversions. Some may not be ready soon. Some may not be smooth-running before the end of 2010.
Employee communications are necessary but potentially confusing and complicated because the tax consequences must be explained.
Plan amendments must be done by year-end, unless the IRS provides a remedial amendment period, which has not yet occurred.
What is the rush?
There is a one-time advantage for distributions made after September 27, 2010 and before the end of 2010 and converted to a Roth account in the plan. The individual can elect to take the taxable amount of the conversion into income ½ in 2010 and ½ in 2011. After that, taxable income occurs when the conversion occurs.
What should employers do?
If an employer wants to implement an in-plan Roth conversion, the first step is to ask the plan's recordkeeper if and when it may be able to implement the change.
If the change can be done, the employer should consider the overall plan design and objectives, employee communications, forms and procedures needed, plan amendments, and the effective date, including how to handle distributions since September 27, 2010 and the implementation date.