Tax deal to avert “fiscal cliff” allows for in-service Roth conversions

Legislation approved by Congress to avoid the “fiscal cliff” would attempt to generate immediate revenue for the federal government by authorizing in-service rollover distributions of 401(k) funds to Roth 401(k) plans. The provision, which was part of the American Taxpayer Relief Act of 2012 (H.R. 8), would be effective for transfers occurring after December 31, 2012. The Act was passed by the House on December 31, 2012, and by the Senate on January 1, 2013, and was signed by the President on January 2, 2013.

Under current law, 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, however, an account may not be rolled over unless it is 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 may 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 59½ or a separation from service.

The amendment implemented by the American Taxpayer Relief Act would allow a plan that includes a qualified Roth contribution program to authorize the transfer of “any amount not otherwise distributable under the plan” 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.

As under current 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.

Distributions from the Roth account will not be subject to tax. The Congressional intention underlying the amendment appears to be to generate an immediate revenue stream for the Treasury by encouraging Roth conversions, while holding out to taxpayers the promise of tax-free distributions in the future.

Source: American Taxpayer Relief Act of 2012.

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For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer’s Benefits Reports.

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