Roth conversions permitted in plans!

In our last newsletter, we noted that Congress was considering a law that would allow for Roth conversions inside of plans, not just from IRA to IRA.  It’s becoming a reality, as the House and Senate recently passed the Small Business Jobs and Credit Act of 2010 including these provisions, and President Obama is expected to sign it any day.

The rules could be clearer, and many of the specifics are not in the bill but are in the Technical Explanations accompanying the bill, but here’s what we think we know, and some pros and cons:

  • A Roth conversion occurs when you transfer money from a pre-tax IRA (or now, a pre-tax plan account) into a Roth IRA (or Roth plan account).  Any money not previously taxed is taxable, although there are no penalties for premature withdrawal.  Under a special rule, the income on 2010 conversions may be recognized in 2011 and 2012.  Subsequent distributions from the Roth IRA/account are tax-free, as long as certain holding requirements are met, generally, 5 years and reaching age 59½.
  • In qualified plans, a conversion of elective deferrals (401(k) money) may be made only after age 59½.  Some fully vested employer money, such as profit sharing and matching contribution accounts (but not “safe harbor” accounts) may be converted after aging for two years, or after the participant has been in the plan for five years.
  • The plan must permit ongoing Roth deferral contributions – it can’t just allow for the conversion.
  • The plan will have to be amended to permit conversions, although perhaps not in 2010.
  • If the plan does not already permit distributions at age 59½ (or after aging 2 years or after 5 years of participation), it does not have to allow other distributions from the plan under similar circumstances.  That is, the age 59½ and 2 year/5 year rules can be restricted to Roth conversions only.
  • All things being equal (current and future tax rates, earnings, etc.) Roth contributions are “better” than regular IRA or 401(k) contributions if you can afford to pay the taxes with other money.  Otherwise, they are neutral from a tax standpoint.  With Roth conversions, you generally can’t use the converted money to pay the taxes, so, generally speaking, if you can afford to do it, it is a good deal – again, all things being equal.
  • You could push yourself into a higher tax bracket and make things “unequal” by dong a conversion.  And you should always think very carefully before incurring taxes that could be deferred.
  • Many people think that tax rates will go up in the future, making the case for a Roth conversion now, but others are concerned that an insatiable need for tax revenue will cause Congress to break its promise that distributions from these accounts will be tax-free, making the case against a Roth conversion.
  • IRA conversions may be “undone” as late as the extended date for filing a personal return (October 15 of the following year, including extensions).  This would be attractive where a conversion is done but the value of the investments subsequently decreases.  In-plan conversions may not be undone.

We’ll keep tuned as details continue to unfold.  Please contact us if you think you’re interested.