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By Joseph S. Adams, Paul J. Compernolle, Maureen O'Brien, Elizabeth A. Savard, Jeffrey M. Holdvogt, Patrick D. Ryan
Employers sponsoring 401(k) or 403(b) plans should give immediate
consideration to recently enacted legislation that allows participants
to convert their retirement accounts in such plans to Roth accounts in
2010 and avoid some of the plan sponsor concerns that existed under
prior law. With a potential increase in individual income
tax rates looming in 2011, plan sponsors may be under pressure from
executives and other plan participants to permit such conversions prior
to the end of the year.
On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010.
The new law permits 401(k) and 403(b) plan sponsors to amend their
plans to permit vested account balances that can be distributed as an
eligible rollover distribution to be converted to Roth amounts within
the plan. Converted amounts are treated as distributions and taxable in the year of conversion.
However, a special rule permits amounts converted in 2010 to be
recognized as income over a two-year period starting in 2011, unless the
participant elects to have the income recognized in 2010.
Prior to the new law, a participant could take a distribution of
retirement plan assets (to the extent permitted under law and by the
plan) and convert the assets outside the plan by rolling over the
distribution to a Roth IRA. The prior law put plan
sponsors in somewhat of a dilemma because if they wanted to allow
participants to maximize the amount of money they could roll over to a
Roth IRA, the plan had to expand its in-service distribution features.
However, if the plan expanded its in-service distribution features,
then those features would need to be offered to a non-discriminatory
cross-section of participants-and some of the participants might use a
distribution for a purpose other than Roth conversions.
This concern about "leakage" from the retirement system caused many plan
sponsors to refrain from expanding their in-service distribution
The new law fixes the "leakage" problem. Specifically,
the legislative history of the new law states that a plan can restrict
its expanded in-service distribution options solely to Roth conversions. In other words, a plan can be amended to permit expanded in-service distributions solely for the purpose of making in-plan Roth conversions.
Now, if the plan permits, a participant or beneficiary eligible to take
an in-service distribution may elect to convert plan assets into Roth
amounts and keep the assets in the plan. As a result, plan
sponsors that were considering amending in-service distribution rules
to permit participants to roll over accounts to Roth IRAs to take
advantage of 2010 tax rules can now amend their plans to liberalize
in-service distribution rules solely for purposes of converting plan
assets into Roth assets inside the plan.
Requirements for In-Plan Roth Conversions
A plan may (but is not required to) permit in-plan Roth conversions
only if the plan is a 401(k) or 403(b) plan that has a Roth elective
deferral arrangement. So, for example, a plan that is only a profit sharing plan would not be eligible to offer in-plan Roth conversions.
If a plan permits Roth conversions, a participant can only convert
amounts that are otherwise distributable under the terms of the plan (as
amended) and qualify as eligible rollover distributions. Under the
Internal Revenue Code, the maximum extent to which in-service
distributions are permissible depends on the type of contribution:
Plan sponsors may amend their plans to permit in-plan Roth conversions for some or all of these types of contributions.
Benefits to Participants
The ability to convert plan assets into Roth assets may be popular
with plan participants because they can choose to convert plan assets
into Roth assets and later take a tax-free distribution, provided the
participant meets the requirements for a qualified Roth distribution.
Participants who are unsure about future tax rates or their future tax
bracket can diversify by converting some retirement plan assets into
Roth assets and maintaining other assets as traditional pre-tax assets.
Conversion may be particularly advantageous for participants in 2010.
As noted above, a special rule allows individuals to delay recognition
of 2010 income until 2011 and 2012 for a Roth conversion.
On the other hand, tax rates are currently scheduled to increase after
2010 (the top marginal tax rate is scheduled to increase from 35 percent
to 39.6 percent), so participants may choose to do a conversion in 2010
but elect not to defer recognition of the converted amount.
Converted amounts are not subject to the 10 percent early
distribution tax under Section 72(t) of the Internal Revenue Code
(generally applicable to distributions to participants under age 59½
that are not rolled over to an IRA).
Challenges and Steps for Plan Sponsors
Plan sponsors may want to permit in-plan Roth conversions in 2010 to help participants take advantage of favorable tax laws. However, a number of issues remain unclear and adoption of in-plan Roth conversions in 2010 may prove challenging.
The most pressing question will be whether plan administrators can handle conversions in 2010.
If in-plan conversions can be administered, decisions will need to be
made on how a participant can make an election, which plan assets can be
converted, how frequently conversions can be made and whether there is a
minimum amount that can be converted at a given time.
Plan administrators and service providers will need to develop systems
and forms to permit elections and track and report conversions. Administrators will need to develop participant notices and communications.
Sponsors of plans that do not currently permit Roth contributions will
need to consider whether they can establish a Roth elective deferral
feature in their plan before the end of 2010 in order to simultaneously
implement in-plan Roth conversions.
A number of other administrative issues related to in-plan Roth conversions are unclear:
The legislative history of the new law states that it is intended that
the IRS provide employers with a remedial amendment period that allows
them a sufficient period of time to amend their plans to reflect the
in-plan Roth conversion options. It is unclear how the IRS
will interpret this remedial amendment period, but action may still be
desirable before year-end to document any new Roth feature or any
expanded distribution rights that are added to the plan.
Joseph S. Adams is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm's Chicago office.
Joe focuses his practice on employee benefits and executive
compensation matters for public, private and tax-exempt organizations.
Paul Compernolle is a partner in the law firm of McDermott Will &
Emery LLP and is based in the Firm's Chicago office. He focuses his
practice on the employee benefits field, advising businesses on a broad
range of employee benefits matters, including establishing and
administering 401(k) and pension plans and the benefits aspects of
acquisitions and sales of businesses.
Maureen O'Brien is counsel in the law firm of McDermott Will & Emery LLP and is based in the Firm's Chicago office.
She focuses her practice on advising clients on a broad range of
employee benefits matters, including qualified plan design, welfare plan
design, employee benefit plan compliance issues, fiduciary matters,
multiemployer pension plan issues and nonqualified deferred compensation
Elizabeth Savard is a partner in the law firm of McDermott Will &
Emery LLP and is based in the Firm's Chicago office. She focuses her
practice on a variety of employee benefits matters, including designing,
amending and administering pension plans, profit sharing plans, 401(k)
plans, cafeteria plans and welfare benefit plans. She has dealt with
the Internal Revenue Service under various circumstances, including
Employee Plans Compliance Resolution System (EPCRS) filings and
applications for tax-qualification determination letters. She has also
advised clients on HIPAA privacy compliance issues.
Jeffrey M. Holdvogt is an associate in the law firm of McDermott Will
& Emery LLP and is based in the Firm's Chicago office.
Patrick D. Ryan is an associate in the law firm of McDermott Will & Emery LLP and is based in the Firm's Chicago office.
He focuses his practice on employee benefits matters related to pension
plans, 401(k) plans, executive compensation arrangements, and cafeteria
and welfare plans.
The content of this article is
provided solely for informational
purposes: It is not intended as, and does not constitute, legal advice.
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