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Apparently, Congress has discovered that expanding the ability of participants to convert their pre-tax retirement accounts to Roth accounts can raise additional tax revenue. And, in their eleventh hour bid to keep us from falling off the fiscal cliff, they did just that.
The American Taxpayer Relief Act opens the doors for Roth conversions. The legislation includes only a single sentence, so details are sparse until the IRS issues guidance on how the new law is to be implemented and managed.
What We Know
The new law extends the ability to convert from pre-tax to Roth to all amounts regardless of the original source of the contributions and even for participants that are not yet age 59 ½.
Some of the basic requirements are as follows:
- Optional: This is not a mandatory provision. Plans can choose whether or not to offer Roth conversions. Those that do can impose restrictions such as limiting conversion to only certain money sources.
- Roth Deferrals: Only plans that otherwise permit Roth deferrals can offer the Roth conversion option.
- Taxes: Participants who convert must include the entire converted amount as taxable income for the year of conversion. There is no option to spread it over two years.
- Reversal: The new law does not provide a mechanism to reverse a conversion once it is made.
- Recordkeeping: Distribution restrictions that apply to certain money types, e.g. no distributions prior to age 59 ½ for deferrals and safe harbor contributions, will continue to apply post-conversion. Therefore, each money source that is converted must be tracked separately, e.g. Match to Roth Match, Safe Harbor to Roth Safe Harbor, etc. Plan sponsors should check with their recordkeepers to find out when this functionality will be available.
- Amendment: Plans that offer Roth conversions must adopt an amendment no later than the last day of the year in which they implement the provision. In other words, calendar year plans that implement this feature during 2013 must adopt a formal plan amendment no later than December 31, 2013.
What We Don't Know But Strongly Suspect
There are several elements that are not clear at this stage. We have listed them below along with the conventional wisdom on how the issue is likely to be confirmed.
- 5-Year Clock for Tax-Free Distributions: For those who do not already have Roth accounts in the plan, the clock would presumably start at the date of conversion. Participants with existing Roth accounts will most likely apply their existing clocks; however, we do not yet have confirmation of that.
- Vesting: Only vested amounts are eligible for conversion. Since this could create post-conversion challenges in partially vested accounts, sponsors choosing to offer Roth conversions may wish to consider restricting them only to accounts that are fully vested.
Rumor has it that the IRS is already working on regulations to provide additional guidance. Although the new Roth conversion option is effective January 1, 2013, we are recommending that plan sponsors wait to implement it until some of the critical questions are resolved.
We will keep you posted. In the meantime, please do not hesitate to contact us with any questions.
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