Legal Alert: IRS Issues Further Guidance Regarding In-Plan Roth
Conversions, but Leaves Questions Unanswered
By: Jeffrey Ashendorf
12/13/2010
Under the Small Business Jobs Act of 2010, since September 27 of this
year, plans have been permitted in certain circumstances to allow
participants (and beneficiaries who are surviving spouses) to convert their
account balances (or portions of their account balances) to "Roth" accounts
within the plan, much like conversion of a regular IRA to a Roth IRA. And,
like an IRA conversion, the amount converted is taxable to the participant as
if it had been rolled over to a Roth IRA, i.e., as if it had been distributed, and
converted after-tax amounts, which would not be taxable on distribution, are
not taxable on conversion. But, in order to be able to elect a conversion, the
participant must be otherwise eligible to receive a distribution that would
qualify as an "eligible rollover distribution", which raises certain questions
concerning the application of the rules governing "eligible rollover
distributions."
First, an "eligible rollover distribution," unless distributed in a direct rollover,
is subject to mandatory 20% income tax withholding. Though the in-plan
conversion is not an actual distribution, it is taxed as if it were distributed, as
opposed to being non-taxable like a direct rollover. On the other hand, rather
than actually being an "eligible rollover distribution", the amount converted is
an amount that otherwise would have been able to be distributed as an
"eligible rollover distribution." So is it subject to 20% withholding? Or any
withholding at all?
Second, since the amount converted is not thereby excluded from gross
income (as would be the case if it were rolled over to a non-Roth account), is
the taxable amount also subject to the 10% tax penalty if the participant has
not reached age 59-1/2, and is not eligible for another exception?
Third, how is an in-plan conversion supposed to be reported, given the
similarities to and differences from both regular distributions and rollovers?
What about reporting a distribution of – or a distribution that includes –
converted amounts?
The IRS has provided answers to these questions, but has done so on its
website, under "Changes to Current Tax Forms, Instructions, and
Publications," rather than issuing a formal Notice (see
http://www.irs.gov/formspubs/article/0,,id=109875,00.html).
First, it confirms that there is no withholding required from an amount that is
being converted (i.e., no 20% withholding). But still unanswered is whether
the participant who elects to convert and to incur taxable income may
choose to have tax withheld from the converted (or convertible) amount; if
so, since the amount withheld will not have been converted, would that
amount itself constitute a real "eligible rollover distribution"? Of course, the
participant will have additional tax obligations resulting from the conversion,
and the IRS has noted elsewhere (see Notice 2010-84) that the participant
"may have to increase his or her withholding or make estimated tax
payments to avoid an underpayment penalty", but the participant may prefer
to satisfy that obligation through withholding in connection with the
conversion, if that is possible.
Next, it confirms that the 10% tax penalty does not apply in the case of an
in-plan conversion. However, depending upon the answer to the above
"voluntary withholding" question, there would also be a question concerning
whether amounts withheld, which would be taxable, would also be subject to
the penalty.
Third, the IRS advised that – at least for 2010 conversions – an in-plan
conversion should be reported on Form 1099-R, using code G (normally
used to indicate a non-Roth direct rollover). This should be fairly
straightforward, but it does not address whether multiple codes can or
should be used, if applicable, as they usually would be.
Finally, the IRS stated that any portion of a distribution from a designated
Roth account that is allocable to an in-plan Roth conversion should be
identified by indicating the amount in the blank box to the left of box 10 on
the Form 1099-R on which the distribution is reported. However, where a
distribution consists of both converted amounts and other Roth amounts, the
distribution may be qualified in part and nonqualified in part (due to differing
5-year periods), making different distribution codes applicable to the different
portions of the distribution, but such reporting presently cannot be done on a
single Form 1099-R. There already are detailed ordering rules dictating how
distributions are to be allocated among taxable and nontaxable portions of
both in-plan Roth conversions and other Roth balances, and separate
reporting would be required in order to reflect those allocations.
Hopefully, these and other questions will be answered in further guidance.
If you have any questions regarding new Roth conversions or any action you
are required to take in order to provide such conversions in your plan.
Please contact the author of this Legal Alert, Jeffrey Ashendorf, at
jashendorf@fordharrison.com, any other member of Ford & Harrison's
Employee Benefits Practice Group, or the Ford & Harrison attorney with
whom you usually work.
