Congress continues to work (or some might suggest not work) in its typically convoluted motif. Among the tax law changes in the American Taxpayer Relief Act (ATRA) (also known as the fiscal cliff compromise bill) is a provision expanding the availability of Roth conversions inside defined contribution, 403(b) and 457(b) plans. One might think of lots of good policy reasons for this expansion (like reducing plan leakage; giving participants greater flexibility for retirement planning), but Congress did not pass this law for good policy reasons. It passed it to raise revenue, plain and simple. This part of ATRA was scored by the Congressional Budget Office to raise $12.2 billion over 10 years. In fact, Roth expansion was not one of the considered tax law changes debated since the election. This is the second time that Roth conversion inside qualified plans has been used for the purpose of raising revenue, although the first time there was the pretext of reducing plan leakage. The last time was with Small Business Jobs Act of 2010 (H.R. 5297).
So what does the new law do? To understand it, let’s first look at what the conversion rules were before 2013. Before ATRA, traditional amounts in defined contribution, 403(b) and 457(b) plans could be converted to Roth amounts within the plan if two requirements were met: (1) the amounts were eligible for distributable rollover; and (2) the plan allowed for regular non-rollover Roth contributions.
The new law eliminates that first requirement beginning in 2013. Therefore, participants in 401(k) plans no longer need to have terminated employment or be at least 59-1/2 in order to convert their accounts. Additionally, it appears a plan no longer needs to provide for an age 59-1/2 distribution right for the amount to be eligible for an in-plan Roth conversion. All vested amounts in defined contribution, 403(b) and 457(b) plans are eligible for conversion. The plan must still allow for regular non-rollover Roth contributions, and unlike with conversions in IRAs, there is no provisions for revocation, i.e., an in-plan conversion is irrevocable.
Special features applicable to pre-2013 in-plan conversions should still apply. These include:
- If part of the conversion involves a participant loan, it can be converted to Roth without being treated as a new loan.
- No early distribution excise tax will be due for those under age 59-1/2.
- Conversions should not be subject to the new 3.8% tax on net investment income of higher income taxpayers.
- No spousal consent is required for a conversion, even if the plan requires spousal consent on distribution.
- A notice of the right to defer a distribution is not required.
- If the converted amount is subject to protected benefits (such as certain distribution rights), they still apply after conversion.
- Conversions are not subject to either 20% or optional withholding, but underpayment penalties may apply.
- Surviving spouses, alternate payees who are former spouses or surviving spouses may convert their accounts.
This new flexibility should make lots of work for financial planners. There are definite tax advantages for many plan participants, but it’s important for someone who understands the vagaries to analyze whether or not conversion makes sense in individual situations. Plan sponsors whose plans don’t currently provide for Roth accounts should also be busy determining whether or not to add the Roth option to their plans. If they opt to do so, a plan amendment and a summary of material modifications will be need to be prepared.