In-Plan Roth Rollover Guidance
Rev. 12/08/10; E-mail Alert 2010-18

On November 26, 2010, the IRS issued Notice 2010-84, providing guidance for in-plan Roth rollover provisions within 401(k) plans, 403(b) plans and as of next year governmental 457(b) plans.  This guidance supplies the retirement plan community with answers to the many questions that have arisen regarding the implementation, ongoing administration, and reporting of in-plan Roth conversion.

The in-plan Roth conversion rollover option became effective September 27, 2010 with the passing of The Small Business Jobs Act of 2010 (H.R. 5297)(SBJA). Notice 2010-84 is presented in question and answer format, and consists of 20 questions that clarify the in-plan Roth conversion rules. 

In-Plan Roth Conversion Methods
An in-plan Roth conversion can be accomplished by either a direct rollover into a designated Roth account or by distributing the funds to an individual who then rolls over the account into a designated Roth account within 60 days. (Q/A-1)

Eligible Participants
In addition to plan participants, a surviving spouse beneficiary or spouse/ex-spouse who is an alternate payee may also elect an in-plan Roth rollover. (Q/A-14)  Note that nonspouse beneficiaries may only make a direct rollover conversion to an inherited Roth IRA.

Distributable Event Required
As with the conversion to a Roth IRA, a distributable event that qualifies as an eligible rollover distribution is required to make an in-plan Roth conversion. Plans that offer the in-plan Roth rollover feature to active participants must allow for in-service withdrawals.  A plan that currently does not offer in-service withdrawals can be amended to add in-service withdrawals solely for in-plan Roth rollover purposes and restrict active participants from taking other in-service withdrawals from the plan. 

A Plan that currently offers in-service withdrawals may not be amended to restrict these types of distributions solely to in-plan Roth rollovers.  Placing a restriction on a pre-existing in-service distribution option would be an anti-cutback violation under §411(d)(6). (Q/A-4)

Example: A plan currently allows in-service withdrawals of elective deferrals at Normal Retirement Age which is defined as age 65. Subsequently, it adds an in-plan Roth rollover feature and restricts all in-service distributions solely to in-plan Roth rollovers. This would violate the anti-cutback rules of §411(d)(6). However, if as part of adding the in-plan Roth rollover feature, a new provision with the age for in-service withdrawals of elective deferrals solely for conversion at age 59½, is added to the plan, the plan sponsor may restrict such in-service distributions solely to in-plan Roth rollovers for those that occur after attainment of age 59½, but leave the in-service at age 65 for distribution of deferrals without violating the anti-cutback rules.

§402(f) Special Tax Notice Requirements
Plans that adopt the in-plan Roth rollover provision must update their §402(f) notice to include a written explanation of the in-plan Roth rollover feature and provide it to all individuals who qualify for an eligible rollover distribution.  Notice 2010-84 includes IRS model language that can be added to existing §402(f) notices (Q/A-5)

Comment: Plan administrative forms related to in-service withdrawals also should be modified accordingly to facilitate in-plan Roth rollovers.

In-plan Roth Rollovers Not Treated as a Distribution for the Following
Although in-plan Roth rollovers are treated as a distribution for tax purposes, they will not be treated as a distribution for the following purposes:

• A plan loan transferred to the designated Roth account (without changing its repayment schedule) is not treated as a new loan;
• Spousal consent is not required in connection with an election to make an in-plan Roth rollover;
• The amount rolled over is taken into consideration for determining whether a participant’s accrued benefit exceeds $5,000;
• Optional forms of benefit may not be eliminated.  A participant who had a distribution right prior to the rollover cannot have that right eliminated after electing an in-plan Roth rollover. (Q/A-3)

Tax Withholding
In-plan Roth rollover amounts are not subject to 20% mandatory federal tax withholding.  However, since taxes are due on pre-tax amounts that are converted, a participant may wish to consider either increasing his or her tax withholding applicable to their wages from employment or making additional estimated tax payments to avoid an underpayment penalty. (Q/A-8)

Taxation
The amount of an in-plan Roth conversion is taxable in the year distributed. A special two year tax treatment for Roth conversions made in 2010 is available for amounts converted in-plan in 2010. The taxable amount includible in a participant’s gross income is equal to the value of the in-plan Roth rollover amount, less any basis (existing after-tax amounts) the participant has converted to the designated Roth account.

If the distribution includes an outstanding loan, the current loan balance is also included as income.

If the distribution includes any employer securities, the fair market value to be taxed includes any net unrealized appreciation. (Q/A-7)

Election to Include in Income for 2010 Taxes or to Use Special Two-Year Tax Method
For conversions made in 2010 only, there is the option to pay tax in 2010 or split the amount in half and pay tax on half in 2011 and half in 2012. An individual election to include the in-plan Roth rollover as income in 2010 cannot be changed after the due date (including extensions) of the individual’s 2010 tax return. (Q/A-10)

The election applies to all pre-tax funds that are rolled over in an in-plan conversion. The election is independent of any election made with respect to a qualified Roth contribution, i.e. conversion to a Roth IRA, from a non-Roth IRA or from a plan account other than from a designated Roth. Thus, taxes due on funds converted in plan to a designated Roth in 2010 may be paid with the 2011 and 2012 tax returns, while taxes due on funds converted from a plan to a Roth IRA may pay taxes on 2010 tax return or vice versa. (Q/A-10)

The individual documents his or her election respecting the tax treatment of an in-plan Roth rollover by completing Form 8606, which is attached to the individual's personal tax return (Form 1040). The employer's reporting responsibility is limited to the preparation of the appropriate Form(s) 1099-R for the year in which the in-plan Roth rollover occurs.

In-plan Roth Conversion Form 1099-R Reporting
The IRS separately issued the Form 1099-R reporting guidance on November 21, 2010.

"Report the amount rolled over in box 1 (Gross distribution), the taxable amount in box 2a, and any basis in the rollover in box 5 (Employee contributions). Use Code G in Box 7 on Form 1099-R. Mandatory 20% withholding does not apply to in-plan Roth direct rollovers.

Distributions made to plan participants in 2010 from designated Roth accounts must be reported on a separate Form 1099-R.  You must report on Form 1099-R the portion of a distribution from a designated Roth account that is allocable to an in-plan Roth rollover. Report the distribution as you would any other distribution from a designated Roth account; however, in the blank box to the left of box 10, enter the amount of the distribution allocable to the in-plan Roth rollover."

Plan Participants - Form 8606 Reporting
The Form 8606 information is a direct quote from the IRS website information:

"Plan participants who make an in-plan Roth rollover in 2010 must:

• File Form 8606, Nondeductible IRAs, with their 2010 tax return
• Complete Form 8606, Part III, to report their in-plan Roth rollover
• Complete certain lines of Form 8606, Part IV, if they receive a distribution in 2010 of any amount of their in-plan Roth rollover
• Complete Form 8606, Part II, to report any amount converted from a non-Roth IRA to a Roth IRA in 2010
• File and complete a separate Form 8606, Part III, if they also rolled over amounts from a qualified retirement plan to a Roth IRA in 2010"

Recharacterization of In-plan Roth Conversions Not Permitted
Once the in-plan Roth conversion has occurred, the participant may not change his or her mind and have the funds changed back to pre-tax assets within the plan. (Q/A-6) Note that recharacterization is available when funds are converted from a traditional IRA to a Roth IRA, provided the recharacterization is accomplished by the tax filing deadline, including extensions.

Income Acceleration
For those choosing the two-year tax payment method, acceleration of income for tax purposes will apply if any of the amounts converted is distributed prior to the due date for payment of taxes under that election. 

Example 1:  An individual converts $12,000 in 2010 and elects the two-year tax treatment. In 2011 he withdraws $4,000 of the converted amount. In this situation, the $4,000 becomes immediately taxable in 2011 in addition to the $6,000 that is already scheduled to be taxed in 2011 as the result of his or her earlier two-year election. This results in a total of $10,000 being taxable in 2011. The remaining $2,000 is taxed in 2012. If the individual is under age 59 1/2, the 10% recapture tax will apply to the $4,000, unless a known exception applies.

Example 2: An individual converts $8,000 in 2010 and elects the two year tax treatment. Subsequently,  $5,000 of the conversion is withdrawn in 2010. In this situation, $5,000 becomes taxable in 2010 and the remaining $3,000 is taxable in 2011. (Q/A-11) If the individual is under age 59 1/2, the 10% recapture tax will apply to the $5,000, unless a known exception applies.

The above income acceleration rule also applies if a Roth conversion amount is moved to another designated Roth account and then withdrawn before tax is due.

Recapture Tax
If a converted amount is withdrawn within five years of the conversion and the individual is under age 59½, the 10% penalty will apply on the amount withdrawn.

Measuring the five-taxable-year period for recapture tax
The five-taxable-year period for determining whether the recapture tax applies starts with the first day of the participant’s tax year in which the in-plan Roth conversion occurred. For most taxpayers, this is usually January 1. It ends on the last day of the individual’s fifth taxable year after the conversion.

Amounts may be rolled to another designated Roth or Roth IRA without penalty; however, if they are withdrawn from the subsequent Roth before the end of the five-taxable-year period the 10% recapture tax will apply.

Comment: A separate designated Roth sub-account should be established for each in-plan Roth conversion in order to appropriately apply the recapture tax or acceleration of income rules.  See a more detailed example of the application of recapture tax and acceleration of income rules below. (Q/A-13)

Measuring the Five-year Designated Roth Clock
The five-year designated Roth clock starts on the first day of the calendar year in which the earliest of the following occurs:

• The in-plan Roth conversion
• The first designated Roth contribution
• A direct rollover of designated Roth contributions from a prior employer’s plan with an earlier contribution starting year

Thus, if the participant already has designated Roth deferrals in the plan at the time of the conversion, their five-year clock is already running. It does not start over for the in-plan rollover amounts.  This applies only to the five-year requirement for tax-free earnings. Still have to keep track of the five-year period for recapture tax purposes

Plan Amendment Extension
401(k) Plans
The deadline for an employer who sponsors a 401(k) plan to adopt an in-plan Roth rollover amendment has been extended to the later of the last day of the year in which the amendment is effective or December 31, 2011. The amendment must be effective retroactive to the date the plan first permits in-plan Roth rollovers.

Safe harbor 401(k) plans
Generally, amendments to safe harbor plans are to be made before the beginning of the year. However, for the in-plan conversion that is not required. For example, a safe harbor 401(k) plan with a plan year beginning July 1, 2010 may operationally comply with the in-plan conversion rules for distributions after September 27, 2010 and the plan year beginning July 1, 2011 without having to be amended for such change in operation until December 31, 2011. (Q&A 18) Note that the in-plan Roth conversion can be added even though it is not in the safe harbor notice.

403(b) plans
The deadline for a 403(b) plan to adopt an in-plan Roth rollover amendment is generally the same as that for the 401(k plan, i.e. by December 31, 2011. However, 403(b) plans have an extension until the later of the plan’s remedial amendment period or the last day of the first plan year in which the amendment is effective. The end of 403(b) remedial amendment period to adopt a 403(b) prototype plan or apply for a determination letter has yet to be announced by the IRS. Note that the amendment must be effective as of the date the plan first permits in-plan Roth rollovers. (Q/A-16)

Governmental 457(b) plans
A §457(b) government plan may not add a Roth contribution feature in 2010. However, it may adopt an amendment to include a designated Roth account after December 31, 2010, and then allow in-plan Roth rollovers.

Note: A profit sharing plan must have a 401(k) provision in order to add the in-plan Roth conversion.

Amendments to Which the Extension Applies (Q/A-17)

• Amendment to add in-plan Roth rollovers
• Amendment to accept rollover contributions by the designated Roth account
• Amendment to permit in-service distributions limited to in-plan Roth conversion
  

A 401(k) or 403(b) plan, or as of 2011, a governmental 457(b) plan, must have a qualified Roth contribution program in place at the time an in-plan Roth rollover provision becomes effective.  (Q/A-19).  A plan can be amended retroactively to add a qualified Roth contribution program.  (Q/A-20) However, to take advantage of the special tax treatment for a Roth conversion taking place in 2010, the qualified Roth contribution program actually has to have been in place at the time of the conversion. (Q/A-19)

NOTE: The plan must have a qualified Roth contribution in place in order to permit in-plan conversions. The guidance (Q/A-20) indicates that to have a qualified Roth contribution program in place means to already have deferral elections permitting Roth deferrals available at the point when the in-plan conversion is to be implemented and if that is in place, the amendment to add the designated Roth provision to the document may be made by Dec. 31, 2011.

The provisions relating to the amendment details of permitting in-plan Roth conversions may be adopted administratively and summarized in the resolution that authorizes the adoption agreement amendment. Those provisions may then be formally set forth in a model amendment that is adopted before the expiration of the remedial amendment period.

Comment: As noted above, a separate designated Roth sub-account should be established for in-plan Roth conversions in order to appropriately apply the recapture tax or acceleration of income rules.  See a more detailed example of the application of recapture tax and acceleration of income rules below (Q/A-13)

Overview of steps to be completed in 2010 to make an in-plan Roth conversion in 2010

1. Board resolution to add the in-plan Roth Conversion to the plan
1. The board resolution should contain specifics, such as:

1. Adding in-plan Roth conversion
2. If there is no designated Roth provision in the plan, stipulation that a qualified Roth program (see 3 below) will be started coincident with the in-plan Roth conversion.
3. If the plan is adding an in-service provision limited to in-plan conversions
4. The plan accepts in-plan Roth rollover contributions to the designated Roth account
5. A sub-account for each in-plan Roth conversion will be part of the designated Roth account

2. Although time is tight, an actual board resolution (or a unanimous consent resolution) must be furnished to document the changes being made

2. 402(f) model notice updated for the in-plan Roth conversion must be provided

3. To satisfy having a qualified Roth program, salary deferral elections permitting participants to defer to designated Roth accounts must be made available to all participants who are eligible to defer at the time the in-plan conversion program is launched

4. Summary of Material Modifications is to be provided, although this step does not have to be complete in 2010.

RECAPTURE TAX AND INCOME ACCELERATION EXAMPLE FROM NOTICE 2010-84, Q/A-13

"In 2010, Participant P, age 45, makes a $100,000 in-plan Roth direct rollover from his profit-sharing account and defers the inclusion of the $90,000 taxable amount of the rollover to 2011 and 2012 ($45,000 in 2011 and $45,000 in 2012). At the time of the in-plan Roth direct rollover, P’s designated Roth account contains $78,000 of regular Roth contributions and $25,000 of earnings.

Since this is an in-plan Roth direct rollover, the rollover amount is separately accounted for within the designated Roth account. Later in 2010, P takes a $106,000 in-service withdrawal from his designated Roth account. The source can only be the in-plan Roth rollover account, since P is under age 59½, which is the earliest the plan allows in-service distributions of elective deferrals from a designated Roth account. At the time of the distribution, P’s designated Roth account consists of:

In-Plan Roth Rollover Account:
In-plan Roth rollover contributions ($10,000 basis)........$100,000 Earnings..............................................................................$6,000
Total................................................................................$106,000

Regular Roth Account:
Regular Roth contributions................................................$80,000
Earnings............................................................................$24,000
Total................................................................................$104,000

Total in designated Roth account....................................$210,000

Under the pro-rata rules of §72, of the $106,000 distribution, $106,000 x
30,000/210,000, or $15,143, is includible in P’s gross income.

All of the $90,857 of the distribution that is a return of basis is allocated to the in-plan Roth rollover account.

P is subject to the additional 10% tax under § 72(t) on $105,143 (the $90,000 taxable amount of the in-plan Roth rollover under the 5-year recapture rule plus $15,143 that is includible in P’s gross income under the pro-rata rules of § 72).

Also, the entire $90,000 taxable amount of the in-plan Roth rollover is includible in P’s gross income for 2010 (rather than being includible in gross income half in 2011 and half in 2012).

Since the amount of the in-plan Roth rollover was $100,000, there is $9,143 that may still be allocated to the rollover. This will be reported on a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., by the trustee if another distribution within 5 years is allocable to this rollover, but none of it will be subject to § 72(t) under the 5-year recapture rule because all the taxable amount of the in-plan Roth rollover has been used up.

If P were eligible for a distribution from his regular Roth account within his designated Roth account, he could have withdrawn $93,333 and none of it would be allocable to the in-plan Roth rollover (because, of the $93,333 distribution, $80,000 is a return of basis and that would be absorbed by the $80,000 basis in P’s regular Roth account). If P withdrew more than $93,333, some would be allocated to the taxable amount of the in-plan Roth rollover even if P asked that the distribution be made from his regular Roth account."

Stay tuned for the announcement of the date of our
Roth Conversion and Portability eSeminar which will include:
the in-plan Roth conversion rules,
the conversion rules to a Roth IRA,
the portability rules,
tax reporting,
and more.