“Blue Book” clarifies application of distribution restrictions following in-service Roth conversions

The “Blue Book” for the American Taxpayer Relief Act of 2012 (P.L. 112-240), as released by the Joint Committee on Taxation in February 2013, clarifies the provisions authorizing in-service rollover distributions of 401(k) funds to Roth 401(k) plans. Significantly, the Blue Book explains that amounts subject to a distribution restriction in a 401(k), 403(b), or 457(b) plan before an in-plan transfer remain subject to the applicable distribution restrictions after the transfer.

CCH Note: The American Taxpayer Relief Act of 2012 was signed by President Obama on January 2, 2013, effective for transfers occurring after December 31, 2012. However, the Act was signed and released without an accompanying committee report or other guidance explaining its provisions. While the in-service rollover provisions were generally straightforward, issues did emerge. Primary among the issues was whether transferred amounts would remain subject to distribution restrictions.

Roth 401(k) conversions

Rollovers may be made from 401(k) plans (as well as 403(b) plans and governmental 457(b) plans) to a designated Roth account. Specifically, if a 401(k) plan (403(b) plan or 457(b) plan) includes a qualified designated Roth contribution program, a distribution to an employee or surviving spouse from an account under the plan that is not a designated Roth account may be permitted to be rolled into a designated Roth account maintained under the plan for the individual.

In a significant limitation under prior law, however, an account could not be rolled over unless it was an eligible rollover distribution under the terms of the plan. Accordingly, amounts (elective deferrals and safe harbor contributions) in a 401(k) plan subject to distribution restrictions could not be rolled over to a designated Roth account. This rule generally prevents taxpayers from executing Roth 401(k) conversions prior to retirement, attainment of age 59 1/2, or a separation from service.

In-service Roth conversions

The amendment implemented by the American Taxpayer Relief Act of 2012 would allow a plan that includes a qualified Roth contribution program to authorize the transfer of “any amount not otherwise distributable under the plan” (including elective deferrals, matching contributions, and earnings) to a designated Roth account maintained for the individual. The transfer will be treated as a distribution contributed in a qualified rollover contribution to the account.

Plans will need to be amended to allow for the expanded in-plan Roth conversions. Employers that wish to operationally allow for such in-plan transfers in 2013 would presumably need to amend their plans before the close of the 2013 plan year.

As under prior law, the taxable amount of the in-plan Roth rollover will be included in the participant’s gross income. The taxable amount is the fair market value of the distribution reduced by any basis the participant has in the distribution. However, in-plan Roth rollovers are not subject to the 10% early penalty tax. Nor will mandatory 20% withholding apply to in-plan Roth direct rollovers. Note, however, as is the case with all Roth 401(k) deferrals, the required minimum distribution rules would continue to apply, necessitating a distribution to the participant upon the attainment of age 70 1/2 or retirement, if later.

Distributions from the Roth account will not be subject to tax. However, an unresolved issue was whether the transferred amounts will remain subject to distribution restrictions.

Distribution restrictions

A plan will not be treated as violating the distribution restrictions applicable to 401(k), (403(b), and 457(b)) plans solely because of an in-plan transfer under the provision. JCT further clarifies that an in-plan transfer is also permitted for an amount that is not distributable for any other reason. For example, if an amount in a profit-sharing plan is not distributable because the requisite fixed number of years have not elapsed, the plan would not be treated as violating the distribution limitation solely by reason of an in-plan transfer of such amount.

With respect to the application of distribution restrictions to transferred amounts, JCT states that, similar to an in-plan Roth direct rollover for otherwise distributable amounts, an amount transferred in an in-plan transfer merely changes the account in a plan under which an amount is held and the tax character of the amount. Thus, the provision authorizing in-service rollovers “does not change the basic character of these amounts as not being distributable under the plan.” For example, an amount subject to a distribution restriction in a 401(k) plan before an in-plan transfer remains subject to the distribution restriction after the transfer. As a further example, JCT advises that an amount in a profit-sharing plan that is not distributable because the requisite fixed number of years has not elapsed remains subject to the distribution restriction for the remainder of the fixed number of years.

Source: General Explanation of Tax Legislation Enacted in the 112th Congress, Joint Committee on Taxation, February 2013.