On September 27, 2010, President Obama signed the Small Business Jobs Act of 2010 into law. Included in the new law are provisions permitting participants in 401(k) plans to convert existing pre-tax accounts to after-tax Roth accounts within the plan. A summary of the new rules is as follows:
1. The new rules became effective immediately on the date of enactment (September 27, 2010).
2. Although 401(k) plans have been permitted to allow after-tax Roth 401(k) contributions since 2006, the new law provides the first opportunity to convert existing pre-tax accounts to after-tax Roth accounts within the plan. Previously, conversions of IRAs were permitted, but conversions of accounts within tax-qualified employer plans were not. Therefore, a participant who wanted to convert assets in a 401(k) plan had to elect a distribution and roll the distribution into a Roth IRA (or roll into a traditional IRA and then convert the IRA to Roth).
3. Although no actual distribution from the plan is necessary (i.e., conversion to a Roth account is just a recharacterization of the amount and not a physical transfer of assets), the participant must be entitled to a distribution of the amount under plan terms and applicable law. Essentially, this means the following:
a. Employers need not permit Roth conversions within their plans. Therefore, this option will be available to an employee only if the employer amends its plan to allow Roth conversions. Further guidance is expected from the IRS on plan amendments, including a period during which plans can be amended with a retroactive effective date, such that conversions can be accomplished as soon as administrative systems are updated to accommodate, with plan amendments to follow.
b. A plan can permit Roth conversions only if it also allows Roth 401(k) contributions on an ongoing basis; a plan’s Roth provisions cannot be limited to conversions.
c. Active employees who have not reached age 59½ will not be able to convert 401(k) accounts or accounts attributable to 401(k) safe harbor contributions.
d. Employer contribution accounts other than 401(k) safe harbor accounts can only be converted if the employee has been a participant in the plan for at least 5 years, or if the contributions have been in the plan for at least 2 years. (Importantly, a plan need not permit actual distributions from the plan under these circumstances; the “distribution” opportunity can be limited to Roth conversion.)
4. As with conversions of traditional IRAs to Roth IRAs in 2010, the individual can elect to recognize the taxable income attributable to a Roth conversion within a plan in two years (2011 and 2012) in lieu of 2010. This decision requires a weighing of the tax deferral opportunity versus the potential for tax rate increases in the near future. (The primary decision of whether to convert to Roth or maintain existing pre-tax accounts is a complicated issue beyond the scope of this explanation.) A conversion within a plan cannot be reversed, i.e., the opportunity to recharacterize a conversion if the timing turns out to be bad (e.g., the stock market crashes the day after conversion) is not available as it is for a conversion of an IRA. Therefore, taxpayers who wish to preserve this opportunity might still want to roll to a Roth IRA, if available.
If you are interested in adding the Roth conversion feature to your plan, please contact Gary Gunnett at 412-288-2210 or ggunnett@hh-law.com.