On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 (the “2012 Act”). The 2012 Act expands the ability of participants in 401(k) and other eligible retirement plans to convert their pre-tax savings into after-tax (or “Roth”) accounts.
Pre-Tax vs. Roth Contributions
401(k) plans (and their sister 403(b) and 457(b) plans for tax-exempt organizations) became widespread because they allow participants to make pre-tax contributions that grow tax-free until distributed. However, 401(k), 403(b) and 457(b) plans can also allow participants to make after-tax Roth contributions instead. Although Roth contributions are subject to income tax when made, qualified distributions of Roth accounts are not subject to tax. As a result, earnings on Roth contributions can completely escape income tax.
Is it better to defer taxes or pay them up front? The answer depends on each person’s individual circumstances. The 2012 Act expands Roth opportunities by making it possible for more individuals to convert pre-tax accounts to Roth accounts.
Until 2010, plans offering pre-tax and Roth options could not provide participants the ability to convert tax-deferred savings into after-tax Roth contributions. That year, Congress enacted the Small Business Jobs Act of 2010 (“Jobs Act”). The Jobs Act gave 401(k), 403(b) and 457(b) plans the ability to allow participants to convert vested tax-deferred amounts into Roth accounts (an “in-plan conversion”). When an in-plan conversion occurs, the amount converted is taxed in the year of conversion, and qualified distributions are then tax-free. The usual 10% early distribution penalty tax does not apply to an in-plan conversion.
Under the Jobs Act, plans that contained Roth options could choose to allow participants to elect in-plan conversions after reaching age 59-1/2 or following separation from service, death or disability. Certain military reservists could also elect an in-plan conversion.
Expanded Ability to Make Roth Conversions
The 2012 Act expands the availability of in-plan conversions by allowing plans to offer the conversion opportunity to all participants – not just those who have attained age 59-1/2 or have separated from service, died or become disabled.
Expansion of in-plan conversions may provide participants with a valuable financial tool. For example, participants may wish to convert pre-tax amounts to avoid the uncertainty of future tax rates, or participants who expect to be in higher tax brackets in the future may wish to convert to pay tax at their current, lower tax rate. At the same time, in-plan conversions carry some risks. An in-plan conversion is irrevocable, so participants cannot undo the conversion if they learn they would have been better off had they not converted. As indicated above, the decision about whether to make an in-plan conversion is not a simple one and will be driven by many personal factors. One important hindrance, however, is that unless a participant has attained age 59-1/2 or separated from service, money generally cannot be withdrawn from the plan to cover the taxes that will be incurred as a result of the conversion (assuming that the plan even permits withdrawals under those circumstances). Thus, participants must have other resources available in order to cover the taxes that will need to be paid as a result of the conversion.
In addition, the IRS has not issued guidance on the 2012 Act’s in-plan conversion provision, leaving unclear the steps that plan administrators must follow. However, guidance is expected to be forthcoming.
Even in the absence of IRS guidance, the 2012 Act’s expansion of in-plan conversions presents an opportunity for plan administrators to evaluate their current benefits and determine whether any changes are warranted. Plans that already have a Roth option and permit in-plan conversions authorized by the Jobs Act should consider whether to expand participants’ ability to convert. Plans that have a Roth option but do not permit in-plan conversions should reconsider whether their participants would benefit from the ability to elect in-plan conversions. Plans that do not provide a Roth option should consider whether their participants would benefit from the availability of a Roth option and in-plan conversions.
Although guidance from the IRS is expected to be forthcoming, it is clear that the expansion of in-plan conversions is a significant change with the potential to provide substantial benefits to a much greater number of plan participants. Plan administrators should consider whether their plans should expand access to in-plan conversions and should be prepared to implement new policies and adopt plan amendments when IRS guidance is issued.