Recent IRS guidance clarifies a number of outstanding questions regarding “in-plan conversions” of non-Roth balances to Roth balances in 401(k), 403(b) and governmental 457(b) plans. In particular, the guidance confirms that converted balances are subject to the same distribution restrictions after the conversion as they were prior to it.
On December 11, 2013, the Internal Revenue Service (IRS) published Notice 2013-74 to provide guidance on converting non-Roth balances to Roth balances in 401(k), 403(b) and governmental 457(b) plan accounts. Although the IRS refers to these as “in-plan Roth rollovers,” we will utilize the more commonly used term “in-plan Roth conversions” in this summary. The new guidance clarifies rules relating to in-plan Roth conversions of both distributable and nondistributable account balances, along with new rules that apply to in-plan Roth conversions of all account balances. Plan sponsors who permit (or are considering permitting) in-plan Roth conversions should review the new guidance to make sure their plans are (or will be) legally compliant and include desired features, such as how often in-plan Roth conversions will be allowed and whether there will be any limitations on amounts that may be converted.
In-plan Roth conversions first became available in 2010 under the Small Business Jobs Act. That law permitted non-Roth balances to be converted to Roth balances if the plan permitted Roth contributions and if the non-Roth balances were both vested and distributable under the plan. Discussion of that law can be found here.
At the beginning of 2013, the American Taxpayer Relief Act (ATRA) added Section 402A(c)(4)(E) to the Code. ATRA allowed employers to permit participants to convert non-Roth balances that were not distributable to Roth balances, provided the plan permitted Roth contributions. A more in-depth discussion of ATRA can be viewed here. ATRA left a number of questions unanswered, some of which the new guidance addresses.
New Guidance on In-Plan Roth Conversions
Most importantly, the new guidance clears up confusion about whether in-plan Roth conversions of otherwise nondistributable amounts would allow plan participants to take in-service distributions of those amounts after converting them to Roth balances. Notice 2013-74 makes it clear that otherwise nondistributable amounts that are converted to Roth amounts in an in-plan Roth conversion remain subject to the same distribution restrictions that applied prior to the conversion. This means, for example, that 401(k) pre-tax deferrals contributed to a non-safe harbor 401(k) plan that are converted to Roth amounts through an in-plan Roth conversion can only be withdrawn by employees due to hardship or attainment of age 59½ and only if the plan allows for such in-service withdrawals. Most commentators predicted that the IRS would interpret the law to include these familiar limitations on in-service distributions to employees, but the new guidance is a welcome clarification on this point for many plan sponsors whose third-party administrators were waiting for official guidance before programming their systems to accept in-plan Roth conversions.
Other highlights of the new guidance include the following:
- Unvested account balances cannot be converted to Roth balances. ATRA was somewhat unclear on this point, but the new guidance explains that an amount must be vested to be eligible for an in-plan Roth conversion.
- In-plan Roth conversions of nondistributable amounts, as permitted under ATRA, can only be accomplished by a direct in-plan Roth conversion and not by a 60-day “indirect” rollover.
- A Section 402(f) notice (which describes rollover options) only needs to be provided when a participant converts an otherwise distributable amount to Roth.
- No withholding is required or permitted on an in-plan Roth conversion of a nondistributable amount. Accordingly, participants making in-plan Roth conversions may need to increase their withholding on future payments or make estimated tax payments to avoid an underpayment penalty.
- Plan sponsors can discontinue an in-plan Roth conversion feature at any time without violating the Internal Revenue Code’s prohibition on elimination of protected benefits under Section 411(d)(6) (as long as the timing of the plan amendment does not discriminate against nonhighly compensated employees, as described in Treasury Regulation Section 1.401(a)(4)-5). Thus, plan sponsors need not make in-plan Roth conversions a permanent feature of their plans.
- The IRS has given plan sponsors a special one-time extension on when plans must be amended to permit Roth deferrals, Roth rollover contributions into a plan or in-plan Roth conversions. Although, generally, the IRS would require plan sponsors to amend their plans by the end of the plan year in which such a Roth feature is added, the IRS is extending the deadline for adopting these amendments to the later of the last day of the first plan year in which the amendment is effective or December 31, 2014. This means that plan sponsors who permitted Roth deferrals, Roth rollover contributions or in-plan Roth conversions in 2013 now have more time to adopt plan amendments reflecting the change. Similarly, safe-harbor 401(k) plans wishing to adopt in-plan Roth conversions of otherwise nondistributable amounts also have until December 31, 2014, to make the change and amend their plans. After December 31, 2014, safe harbor plans can only allow for in-plan Roth conversions of otherwise nondistributable amounts at the beginning of a plan year, and plan sponsors must amend their plans to reflect the change before the end of the plan year in which the new feature is permitted.
- Plan sponsors can restrict the type of contributions eligible for, and the frequency of, in-plan Roth conversions. This could simplify administration of Roth accounts considerably. For example, a plan sponsor could permit in-plan Roth conversions only of pre-tax 401(k) deferrals, or only of amounts that are otherwise distributable or permit only one conversion per participant per year.
- The guidance states that in-plan Roth conversions are treated as distributions for purposes of determining eligibility for special tax rules on net unrealized appreciation (NUA). When a participant takes a lump-sum distribution from a plan that includes an in-kind distribution of employer stock, the participant is taxed only on the cost (or basis) of the stock to the trust at the time it was allocated to the participant’s account, while the increase in value of the shares from that date to the date the participant disposes of the stock (the NUA) is taxed at a more favorable capital gains rate. The new guidance indicates that an in-plan Roth conversion will be treated as a distribution for purposes of NUA, which may affect participants’ ability to utilize NUA treatment upon subsequent distribution and sale of the shares. Accordingly, plan participants should consult their tax advisers when deciding whether to make an in-plan Roth conversion of amounts invested in employer securities.
The new guidance provides welcome clarification to plan sponsors on a number of topics relating to in-plan Roth conversions, while some questions remain unclear. Because legal compliance relating to in-plan Roth conversions is complex, we recommend that plan sponsors consult with their lawyers in designing and implementing an in-plan Roth conversion program.