Roth Conversions after the Fiscal Cliff

The American Taxpayer Relief Act of 2012 (the so—called “Fiscal Cliff Bill”), passed on January 1, 2013, extends the existing limited in—plan Roth conversion option under Internal Revenue Code (“Code”) section 402A to all vested amounts in a participant’s account, including amounts not yet eligible for a distribution. The new rules apply to in—plan Roth conversions in taxable years beginning after December 31, 2012.

Prior to the passage of the Fiscal Cliff Bill, in—plan Roth conversions to designated Roth accounts were significantly limited by the requirement that these conversions can only occur upon a distributable event. As a result, a participant in a plan providing for in—plan Roth conversions generally could not convert his or her pre—tax deferrals until after attaining age 59 and a half. Other contributions, such as employer matching contributions and employer non—elective contributions, were generally subject to a five year participation requirement prior to conversion. Following the passage of the Fiscal Cliff Bill, all vested contributions (and earnings thereon), including pre—tax 401(k) and 403(b) deferrals, governmental 457(b) deferrals, after—tax contributions, employer matching contributions, and employer non—elective contributions are eligible for immediate conversion regardless of whether those amounts are presently eligible for distribution.

For sponsors of 401(k), 403(b) and governmental 457(b) plans that provide for Roth contributions (or those considering providing for Roth contributions) the Fiscal Cliff Bill has made in—plan Roth conversions a more desirable option, because it provides participants with greater opportunity to convert pre—tax amounts into Roth after—tax amounts. Plan sponsors interested in adding in—plan Roth conversions will have to amend their plans to add the feature. In addition, plan sponsors with plans that already provide for in—plan Roth conversions who are interested in expanding the feature as permitted by the Fiscal Cliff Bill, will likely need to revise their plans to provide for such conversions without requiring a distributable event.

The Fiscal Cliff Bill does not change the taxation of in—plan Roth conversions. In—plan Roth conversions will still result in taxable income in the year of the conversion. Participants who make the conversions will therefore need to have assets available to pay the tax. Notably, unlike the temporary relief that was provided when in—plan conversions were first allowed in 2010, the tax for in—plan conversions is incurred solely in the year of conversion, and cannot be spread over two years.

If you have any questions about in—plan Roth conversion, or Roth contributions in general, please contact the Trucker Huss attorney with whom you normally work.