On September 27, 2010, President Barack Obama signed the Small Business Jobs Act into law. The new law makes two changes to the after-tax Roth contribution rules that apply to defined contribution plans. First, the new law allows certain plans to add an "in-plan" Roth conversion option. This option permits a participant to convert pre-tax amounts into Roth amounts within the plan, without requiring the participant to complete a rollover to a Roth IRA. Next, the law permits governmental 457(b) plans to offer after-tax Roth contributions for the first time, beginning in 2011. Both of these changes are optional.
Roth Contribution History
Roth IRAs were first allowed in 1998, but individuals with income over a certain limit have not been eligible to contribute to a Roth IRA. Beginning in 2006, the Internal Revenue Code was amended to allow 401(k) and 403(b) plan participants to make after-tax "Roth" contributions from their pay, regardless of income. Roth contributions are made on an after-tax basis (rather than on a pre-tax basis like traditional 401(k) and 403(b) contributions). If a participant receives Roth amounts in a "qualified distribution" from either a Roth IRA or a 401(k) or 403(b) plan, then the earnings on the Roth contributions are not subject to income tax.
Roth IRA Conversions
Before 2010, individuals with income below a certain limit were eligible to convert a traditional IRA to a Roth IRA by treating the traditional IRA as having been distributed, and paying the resulting income tax. In 2010, the income limit on Roth IRA conversions was lifted, and for the first time, anyone can convert their traditional IRAs into Roth IRAs. Similarly, in 2010, an individual may roll a distribution of pre-tax amounts from a defined contribution retirement plan into a Roth IRA, and thereby convert pre-tax amounts into Roth amounts, by paying the resulting income tax. Prior to the change under the new Small Business Jobs Act, such a conversion could only be accomplished "outside" the plan—that is, the participant was required to request and receive a distribution, and then roll the distribution over to a Roth IRA.
In-Plan Roth Conversions
The new Small Business Jobs Act permits participants in 401(k) and 403(b) plans to make in-plan Roth conversions. To offer in-plan Roth conversions, the plan must also allow after-tax Roth contributions. A plan cannot allow in-plan Roth conversions unless participants are also able to make Roth contributions from their pay.
For a participant to make an in-plan Roth conversion, the participant must be eligible for a distribution under the terms of the plan. 401(k) and 403(b) plans often provide in-service withdrawal options in the case of participants who are over age 59 ½ or who have rolled money over into the plan, and under other permissible circumstances. Only active employees who are eligible to receive an in-service withdrawal, or former employees who have a remaining balance in the plan, can make an in-plan Roth conversion. If the plan does not currently allow in-service distributions, the 401(k) or 403(b) plan may be amended to add a permissible in-service withdrawal, and it is even possible to condition eligibility for the in-service withdrawal on an employee's decision to make an in-plan Roth conversion. Other rules apply.
If a participant completes an in-plan Roth conversion, the participant will be required to pay income taxes on the amounts that are converted, to the extent that such amounts would have been taxable upon a distribution. However, the early payment penalty does not apply.
Plans may add in-plan Roth conversions effective immediately. Favorable income inclusion rules apply to Roth conversions occurring in 2010—the income resulting from a 2010 Roth conversion (whether in-plan or not) may be spread out over the participant's 2011 and 2012 tax years. This may result in some pressure from participants for plan sponsors to decide quickly whether to permit in-plan Roth conversions. Plan sponsors will need to work quickly with their recordkeepers and communications staff to implement and communicate the conversion opportunity. Plan sponsors that add in-plan Roth conversions, or add a Roth contribution feature or in-service withdrawals, will need to amend their plans to reflect these new provisions. Unless future IRS guidance provides additional time, these amendments must be adopted by the end of the plan year in which the change became effective (or December 31, 2010, for a calendar year plan that adds Roth conversions immediately).