Source: McKay Hochman
The in-plan Roth conversion provision of the Small Business Jobs and Credit Act (H.R. 5297) became effective on September 27, 2010. The absence of IRS guidance leaves us with many questions regarding how to implement, administer and report such conversions.
As we stated in our October 1st e-mail alert article, we believe it is best to wait for formal IRS guidance before amending the plan to add in-plan Roth conversions. However, we have received numerous calls that represent the plan sponsors concerns about the tax consequences of not permitting the conversion in 2010. This coupled with the fact that the end of the year is so administratively close has reinforced the urgency to provide answers to our clients’ questions of how to make in-plan Roth conversions happen this year. This article is our response to those questions and some additional outstanding issues.
Service providers and employers who want to add this provision pending release of formal guidance must ensure appropriate steps are taken. This article discusses some of the operational requirements that are needed to implement in-plan Roth conversions, as well as providing our views on some of the unresolved issues impacting ongoing administration, disclosure and reporting. Keep in mind that prior to IRS guidance, this article is only able to be based on the new law and its joint committee report and that we will be updating our website once IRS issues its guidance.
An Alternative Approach
Most document providers will likely wait to draft model amendments until the IRS releases guidance. This is not expected to occur until later this year or in 2011. In the interim, employers who want to add the in-plan Roth conversion feature should draft an enabling board resolution. A plan must allow for designated Roth contributions in order to add the in-plan Roth conversion feature. If a plan does not permit Roth contributions currently, it must be so amended before or simultaneously with the addition for in-plan Roth conversions. Further, a plan that does not permit in-service withdrawals must be amended to add appropriate distributable events before or simultaneously with the addition of in-plan Roth conversions. Lastly, if the employer wishes to take advantage of the joint committee option to limit in-service withdrawals to Roth conversions, that limitation must be included in the enabling board resolution since current plan documents do not have such a provision.
Keep in mind, that after SBJPA in the late 1990s until the GUST prototype circa 2002, prototype safe harbor 401(k) plans were documented only by a board resolution because preapproved plans did not have 401(k) safe harbor language (until the GUST prototype).
Participant disclosure may be accomplished by issuing a Summary of Material Modification (SMM) that must be distributed to inform participants of this amendment. Normally, SMMs do not have to be issued until 210 days after the end of the plan year in which the plan was amended, but in this case earlier issuance will be most helpful. The SMM should also clarify when in-service withdrawals are limited to in-plan Roth conversions, if this option is adopted. It may be advisable to clearly state that a distributable event is necessary for conversion. Even more importantly, it is recommended that a conspicuous statement regarding the tax consequences of an in-plan Roth conversion be included in the SMM.
The distribution of a revised 2010 Safe Harbor Notice (and 2011, if already distributed) also will be required to disclose the new conversion option and it’s impact on the plan’s in-service withdrawal options and the addition of Roth deferrals, if applicable.
An in-plan Roth conversion option can be added to the forms, or participants may simply write in their election if an “Other” section is available as a distribution reason option on the current distribution form.
As described in the joint committee report, the transaction is a direct rollover taxable distribution (only permitted for eligible rollover distributions) and a rollover into the designated Roth account. Even though the transaction is generally processed like a transfer within the plan (i.e. no check needs to be written or processed), it is a direct rollover. Thus, since there is a taxable event, a Form 1099-R would be the information return issued to report taxable events from retirement plans. The reason code to be utilized needs to be addressed by the IRS, it may be a Code G for direct rollover or it may be a new code designed to distinguish this transaction.
Additional Open Issues for Those Considering Adding In-Plan Roth Conversion Prior to IRS Guidance
Joint Committee 401(b) Amendment Deadline Suggestion
The Joint Committee report suggested that the IRS permit a remedial amendment period under Code Section 401(b). This permits amendments to be made as late as the end of the remedial amendment period (RAP) deadline. Since the RAP deadline under the six-year cycle for defined contribution plans just ended on April 30, 2010, theoretically, the next RAP will be in accordance with the next six-year cycle, which hypothetically could be in the year 2016.
Generally, under Revenue Procedure 2007-44, discretionary amendments must be made by the end of the plan year for which they are effective. However, due to the special tax circumstances surrounding making a conversion in 2010, if the IRS does not issue guidance in time for amendments to be drafted and signed by employers before year end, hopefully they will use 401(b) to provide some additional RAP beyond December 31, 2010 for any new model amendment and model language to be amended to a plan.
There Are No Designated Roth Ordering Rules
The under age 59½ early withdrawal 10% excise tax that is waived when the conversion was made will be applied as a “recapture tax” if the conversion funds are withdrawn within five years after the conversion. IRS guidance is required to create ordering rules or to provide another method of handling a partial distribution that occurs before age 59½ to a participant that has both Designated Roth deferrals and an in-plan conversion to a Designated Roth within 5 years of the conversion. Currently, nonqualified designated Roth distributions are required to be treated as pro-rata earnings and designated Roth contributions. Since there are no ordering rules, this would require guidance and likely a change to current designated Roth regulations. It may be wise to segregate Roth conversions from any designated Roth deferrals until the IRS issues guidance.