Roth In-Plan Rollover Rules Require Action This Year

While the Fiscal Cliff Deal of a year ago did not change the current tax treatment of retirement savings, it did provide some flexibility for retirement accounts. Specifically, it included a provision for retirement plans allowing for in-plan Roth conversions of defined contribution plan accounts that otherwise were not distributable without income limitations.

Previously, only amounts deemed distributable (such as when a participant reached 59 1/2) could be converted to Roth accounts. This conversion feature was expanded to all participants (assuming the feature is offered by an individual’s plan). The provision was effective January 1, 2013. However it took the IRS almost a year to issue clarification.

Of course none of this was done to make managing a retirement plan easier, but purely to raise an estimated $12.2 billion in tax revenue over 10 years to, in effect, defray the cost of the two-month delay the Fiscal Cliff cost the government.

So what does this mean for plan administrators? IRS Notice 2013-74 says plan sponsors must amend their plans to include the conversions to Roth accounts by the end of this year. This amendment is separate from the normal ones such as the restatement of plan documents (usually required every fifth year for individually designed plans and every sixth year for pre-approved plans) or an amendment due to something the employer does (such as change eligibility provisions or add loan features).

Even if you have just amended your plan or plans for restatement or employer-generated reasons you must amend them again “technically an interim amendment” by the end of this year in order to reflect the Roth in-plan rollover rules.

On a positive note, the expanded Roth conversion feature is likely to boost Roth adoption rates by plan sponsors and participants, according to a Vanguard paper, Roth adoption and the new in-plan conversion

A plan sponsor can now offer a Roth feature that allows participants to convert all plan assets (including employer and employee pre-tax contributions and earnings) to Roth savings. Important – to offer Roth in-plan conversions, a defined contribution plan must also offer Roth elective deferrals. To date, Roth features have not been that well utilized. According to Vanguard, of the DC plans that offered Roth elective deferrals only 11% of participants accessed the option prior to the change.

Interestingly, younger participants may be most likely to utilize the new feature. According to another Vanguard report, How America Saves 2013, participants aged 25 and younger were most likely to use it (18 percent), compared with 4four percent of those 65 or older.

Before you rush to promote Roth conversions to younger savers, however, make sure you advise them to get professional tax advice. Roth may not be for those who qualify for certain tax credits (e.g., earned income). And, because it is so complicated, those who use it can inadvertently push themselves into a different tax bracket. Moreover, participants making a Roth decision today may not withdraw those savings for 50 years or more and may not see the tax benefit “if any” until then.

To address future tax uncertainty the best solution is tax diversification. And for this, offering Roth savings increases the options you provide your participants since holding both pre-tax and Roth balances can provide a hedge against uncertainty in future tax rates.

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