New Law Facilitates Roth Conversions

Thomas M. White
ARNSTEIN & LEHR LLP 120 SO U T H RI V E RSI D E P L A ZA | SU ITE 1200 CHI CA G O , I L 60606 P 312.876.71 84 | F 312.876.0 288 tmwhite@arnstein.com

Until recently, a plan participant who received a distribution from his pre-tax non-Roth retirement plan account could convert that distribution to a Roth only by transferring his plan distribution to an IRA. Under the recently enacted Small Business Jobs Act of 2010,

participants in 401(k) or 403(b) plans may convert their pre-tax accounts to Roth accounts without the need for an IRA transfer. In other words, the participant’s funds may be

recharacterized as Roth accounts while being retained in his retirement plan. In order to permit this conversion, an amendment to the employer sponsored plan is required. Roth qualified accounts have two advantages over their non-Roth counterparts. First, qualified distributions from Roth accounts are free from federal tax. However, in order to convert to a Roth IRA or Roth account within a 401(k) or 403(b) plan, the participant must pay federal income tax on the amount that has been converted. And second, Roth accounts are not subject to the Internal Revenue Code’s minimum distribution rules. Thus, the full amount in a Roth account may increase tax free without the requirement for any distributions during the owner’s lifetime. Once an individual has determined - - after careful analysis - - that a Roth conversion is in his best interest, he may have another decision to make. Should he transfer his plan distribution to a Roth IRA or convert it to a Roth account in his 401(k) or 403(b) plan? Retaining the benefit in an employer sponsored plan may be preferable because a participant may prefer the investment choices provided under the plan. A Roth conversion within a plan eliminates the need to make investment decisions necessitated by an IRA transfer. In addition, it is possible that expenses and charges will be less under an employer’s plan than these expenses charged under an IRA. This change is effective immediately and may be made available provided certain conditions are satisfied.

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The participant’s account must be held in either a 401(k) or 403(b) plan. The plan permits active participants to contribute to a Roth account. The plan is amended to permit the Roth recharacterization. The participants’ account must be in pay status - - for example, the benefit could be payable upon termination of employment or if the Code’s in-service distribution rules are available and satisfied under the plan documents. Roth conversions have been the subject of increasing interest because the law permits

taxpayers to spread the tax due on the conversion over several years if the conversion is made promptly. Employers that sponsor 401(k) or 403(b) plans may therefore be expected to receive requests for this opportunity from some of their plans’ participants. It is likely that the participants most interested in a Roth conversion are highly paid employees because they are the individuals who will have available the cash required to pay the income tax due on the amount recharacterized as a Roth account. Employers should determine whether it is

advisable to amend their profit sharing (including 401(k)) plans to permit Roth conversions. Because of the time involved in reaching a decision and the tax advantages of Roth conversions, this analysis should be undertaken and completed promptly.

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