When I first started practicing law, a veteran in this area told me that the only way to make sense of the Internal Revenue Code was to understand that each provision existed so that Congress could make money. Does that explain why, as we reported last year, the American Taxpayer Relief Act of 2012 allowed any amount in a non-Roth account in eligible retirement plans (401(k) plans, 403(b) plans, and governmental 457(b) plans) to be converted to a Roth account in the same plan, whether or not the amount was distributable? Previously, plans could allow participants to convert their pre-tax accounts to Roth accounts only with respect to amounts the participants had a right to take out of the plan. Well, by taxing the amounts so converted from pre-tax to Roth, this change in the tax law is expected to produce an extra $12 billion in revenue for the federal Treasury. Does that make participants who convert their pre-tax amounts to Roth amounts suckers? Not at all.
While it’s easy to be cynical about Congress, let’s give Congress credit for understanding the policy reasons for wanting to allow more flexible tax planning. This type of change has been long supported by the employee benefits community because of the flexibility it gives participants in choosing when to recognize taxable income under their retirement plans. The problem was that without guidance from the IRS, plan sponsors were reluctant to amend their plans to adopt such a feature.
Recently, the IRS published Notice 2013-74 (the “Notice”), which provides additional guidance that plan sponsors had been seeking. The guidance gives plan sponsors much flexibility in how they offer an in-plan Roth conversion feature. In many cases, the flexibility will be the greatest if plan sponsors amend their plans by December 31, 2014. As such, we recommend that plan sponsors consider whether an in-plan Roth conversion feature will be attractive to participants, and if so, act sooner rather than later to amend their plan documents. This blog will explain in more detail why participants may value such a feature and the flexibility that the IRS gave plan sponsors in the Notice.
Flexibility for Participants
In the past, conventional wisdom held that individuals should minimize their current taxes as much as possible and defer taxable income as far into the future as they could. Under this strategy, amounts that otherwise would have been used to pay taxes instead could be reinvested to generate greater returns and then be withdrawn at a later date when the individual’s tax rate presumably would be lower. Today, a more nuanced approach is needed. The top federal income tax rate, while low by historical standards, has increased in recent years. Further, an individual’s income could be high enough to trigger additional Medicare taxes or phase-outs of deductions. As such, some people may be able to reduce their total tax liability by paying some taxes sooner rather than later.
That is why the ability to convert pre-tax amounts to Roth amounts in an eligible plan could be a valuable tax planning tool for participants. Participants who believe that they could be in a higher tax bracket when they retire (either because they believe their taxable income will grow, pushing them into a higher bracket, or because they believe that marginal tax rates will increase) could use this feature to convert some or all of their pre-tax amounts to Roth amounts. The Notice allows participants to convert pre-tax elective deferrals, matching contributions, and non-elective contributions to Roth amounts. Further, participants could decide whether to begin distributions when they retire (or earlier, if the plan has an in-service distribution feature) or wait until their required minimum distribution date. One thing participants should be alert for is that in-plan Roth conversions are not subject to withholding. As such, they may need to increase withholding on other amounts or make estimated tax payments.
Still, the tax planning opportunities abound, and Congress should be commended for providing these opportunities to participants (even if Congress was motivated by revenue raising concerns).
Flexibility for Plan Sponsors
An in-plan Roth conversion feature offers flexibility to participants, but what about the plan sponsors? This is where the IRS should be commended. The Notice gives plan sponsors much flexibility in how to design an in-plan Roth conversion feature. For one thing, sponsors can decide whether to allow participants to convert all pre-tax amounts to Roth amounts, or whether to allow conversions for only some types of pre-tax amounts. As stated previously, plan sponsors will not have any withholding obligations with respect to converted amounts. Roth conversion features also are not considered protected benefits. In other words, a plan sponsor that adopts this feature could decide in the future to restrict its scope or eliminate it completely, so long as the takeaway is applied on a non-discriminatory basis.
The main requirement for plan sponsors is that they need to amend their plan documents to describe the in-plan Roth conversion feature. In this regard, the IRS also was lenient towards plan sponsors. Sponsors of 401(k) and governmental 457(b) plans may amend their plans to adopt an in-plan Roth conversion feature by the later of the last day of the first plan year in which the amendment is effective, or December 31, 2014. Further, safe harbor 401(k) plans may adopt this feature mid-year so long as they amend the plan by December 31, 2014. Generally, safe harbor plans are prohibited from making changes to their plans that take effect in the middle of a plan year, with certain exceptions. This temporary relief provides an exception to that prohibition.
Sponsors of 403(b) plans have even more time to amend their plans for this provision. That is because if a plan sponsor adopted a 403(b) plan document based on the IRS model by December 31, 2009 (or if later, the date the plan became established), then document may be amended retroactively for any guidance published after the date the model was first published by the end of a remedial amendment period that the IRS will publish at some point in the future. That’s expected to be over a year from now. This remedial amendment period applies to in-plan Roth conversion features too.
The bottom line is that the ability to convert pre-tax amounts to Roth amounts, regardless of whether they currently are able to be distributed from the plan, is a feature that many participants will find attractive. Further, the IRS has given plan sponsors great flexibility in how they amend their documents to add such a feature. Plan sponsors should first decide whether they want to offer such a feature, and if so, to what extent they will offer it. If they decide to offer this feature, they should work with counsel sooner rather than later to amend their documents by no later than the end of the year.