Source: http://www.jdsupra.com/legalnews/view-from-mcdermott-expanded-in-plan-co-46031/
Timestamp: 2016-05-01 13:40:50
Document Index: 373188994

Matched Legal Cases: ['§ 402', '§ 402', '§ 1', '§ 402', '§ 402', '§ 1', '§ 414', '§ 1', '§ 402', '§ 402', '§ 402', '§ 408', '§ 402', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 402', '§ 402', '§ 1']

Originally published in Pension & Benefits Daily. Please see full alert below for more information. Download PDF Reproduced with permission from Pension & Benefits Daily, 62 PBD, 04/01/2014. Copyright  2014 by The Bureau
of National Affairs, Inc. (800-372-1033) http://www.bna.com
View From McDermott: Expanded In-Plan Conversion Opportunities Will Boost Roth
BY NANCY S. GERRIE, DIANE M. MORGENTHALER
AND JOSEPH K. URWITZ
T he number of defined contribution plans (including401(k), 403(b) or 457(b) plans) with a Roth featurehas grown significantly in recent years. Roth
401(k) is gaining popularity due in part to tax hedging
or tax diversification strategies. Since the federal and
state tax rates that apply at retirement are unknown, a
participant can hedge future tax exposure by making at
least some portion of his or her retirement savings as
Roth 401(k) contributions. Other participants want
greater retirement security with a large portion of their
retirement savings not subject to income taxes. Some
high net worth participants want to pass tax-free invest-
ments to their beneficiaries.
Whatever the reasoning, Roth 401(k) is gaining trac-
tion in employer-sponsored defined contribution plans.
According to a survey of 400 plan sponsors in October
2013, 50 percent offered a Roth option in their 401(k)
plans, as opposed to 11 percent only five years earlier.1
The number of participants with access to Roth fea-
tures, and the size of their Roth 401(k) balances, should
continue to surge following the issuance of new IRS
guidance2 that greatly expands participants’ ability to
convert retirement savings to Roth balances.
Roth 401(k) is an outgrowth of the Roth IRA and a
creature of the Internal Revenue Code.3 Plan sponsors
have been permitted to adopt Roth features in their
401(k) plans since 2006, following enactment of the
Economic Growth and Tax Relief Act of 2001. Prior to
that, the Taxpayer Relief Act of 1997 established the
Roth IRA, but the Roth IRA has lower annual contribu-
tion limits than the Roth 401(k) and has maximum an-
nual income limits for contributing individuals that
don’t apply to a Roth 401(k). However, while employees
1 ‘‘2013 Trends & Experience in Defined Contribution
Plans: An Evolving Retirement Landscape Highlights,’’ Oct. 30,
2013, p. 1, available at http://www.aon.com/attachments/
human-capital-consulting/2013_report_Trends-Experience-
DC-Plans_Highlights.pdf (last visited March 24, 2014). In 2012,
56 percent of participants in Vanguard’s defined contribution
prototype plans also were offered a Roth option. ‘‘Research
Note: Roth adoption and the new in-plan conversion feature,’’
May 15, 2013, p. 2 available at https://
pressroom.vanguard.com/nonindexed/5.15.2013_Roth_
Adoption_and_the_New_Inplan_Feature.pdf (last visited
March 24, 2013).
2 The guidance relates to the expansion of the rollover rules
under 26 U.S.C. § 402A(c)(4)(E), as added by Section 902 of
the American Taxpayer Relief Act of 2012 (ATRA), Pub. L. No.
112-240 (Jan. 4, 2013); see also IRS Notice 2013-74, 2013-52
I.R.B. 819 (Dec. 11, 2013).
3 26 U.S.C. § 402A.
Nancy S. Gerrie (ngerrie@mwe.com) and
Diane M. Morgenthaler (dmorgenthaler@
mwe.com) are partners in the Employee Ben-
efits Practice Group at the law firm of McDer-
mott Will & Emery LLP and are based in its
Chicago office. Joseph K. Urwitz (jurwitz@
mwe.com) is a partner in the firm’s Employee
Benefit Practice Group and is based in its Bos-
Pension & Beneﬁ ts Daily ™
can make Roth IRA contributions without employer in-
volvement, employees may only make Roth 401(k) con-
tributions if their employer adopts a Roth feature in
their 401(k) plan.
Comparing Roth 401(k), Pretax 401(k) and
Roth 401(k), pretax 401(k) and after-tax contribu-
tions all share certain features, such as a plan sponsor’s
ability to make a matching contribution and to offer
participant loans. Although legally not required, many
plan sponsors provide identical matching contributions
on pretax 401(k) and Roth 401(k) contributions, and al-
low participants to borrow money from their defined
contribution plan based their Roth 401(k), pretax
401(k) and after-tax contribution balances.4
However, the Roth 401(k) contribution is essentially
a hybrid contribution because it shares some features
with pretax contributions and some features with after-
tax contributions. For example, both Roth 401(k) con-
tributions and pretax 401(k) contributions have the
same maximum contribution limits, nondiscrimination
testing and in-service withdrawal restrictions.
Specifically, in 2014, the maximum amount that a
participant may make in both Roth 401(k) contributions
and pretax 401(k) contributions is limited to $17,500,
and the maximum amount of both Roth 401(k) catch-up
contributions and pretax 401(k) catch-up contributions
is limited to $5,500.5 Likewise, Roth 401(k) contribu-
tions are subject to the same average deferral percent-
age (ADP) nondiscrimination test as pretax 401(k) con-
tributions.6 Also like pretax 401(k) contributions, Roth
401(k) contributions can be withdrawn during employ-
ment if the employer’s plan permits and if the partici-
pant is over age 59-1/2, becomes disabled or experi-
ences a financial hardship.7
Even though Roth 401(k) contributions share many
traits with pretax 401(k) contributions, Roth 401(k)
contributions also share a few traits with after-tax con-
tributions. Both after-tax contributions and Roth 401(k)
contributions are included in a participant’s taxable in-
come in the year they are contributed to the plan. Be-
cause Roth 401(k) contributions are included in the par-
ticipant’s taxable wages8 when made to the defined
contribution plan, to reach the maximum contribution
limit of $17,500, more than this amount is reduced from
the participant’s wages ($17,500 plus taxes owed on the
Unique Tax Rules for Distributions and Rollovers
In certain respects, Roth 401(k) contributions are dif-
ferent from both pretax and after-tax contributions.
Specifically, Roth 401(k) contributions have unique tax
rules for distributions and for rollovers. Although Roth
401(k) contributions are taxed upon initial contribution,
if a Roth 401(k) distribution is ‘‘qualified,’’ then any
earnings on the Roth 401(k) contributions can escape
taxation.9
A Roth 401(k) distribution is qualified only if the par-
ticipant’s Roth 401(k) account is at least five years old
and if the Roth 401(k) distribution occurs after the par-
ticipant reaches age 59-1/2, becomes disabled, or dies.10
The five-year holding period for a Roth 401(k) contribu-
tion begins January 1 of the first year a participant
makes a Roth 401(k) contribution.11 In case of a partici-
pant’s death, a distribution does not automatically be-
come qualified, since the distribution also must comply
with the five-year holding rule. If the Roth 401(k) ac-
count of the deceased is less than five years old, the
death distribution will only be qualified if either: (i) the
alternate payee or spousal beneficiary rolls the distribu-
tion into a designated Roth account maintained by his
or her own employer,12 or (ii) the beneficiary keeps the
Roth 401(k) contributions in the plan until the five-year
holding period has passed.
Under another unique tax distribution rule, Roth
401(k) contributions can evade minimum distribution
rules at age 70-1/2. Although Roth 401(k) contributions
in a defined contribution plan are subject to minimum
distribution requirements at age 70-1/2, a participant
can avoid the normal minimum distribution require-
ments by choosing to directly roll over his or her Roth
401(k) contributions and applicable earnings to a Roth
IRA.13
Roth 401(k) contributions also have unique tax roll-
over rules. Roth 401(k) rollover rules differ from those
of all other contributions with a distinction between di-
rect rollovers and indirect 60-day rollovers. A partici-
pant can make a direct rollover of both Roth 401(k) bal-
ances and earnings to either a Roth IRA or another Roth
401(k) account.14 However, if a participant receives an
indirect rollover (a direct distribution to the partici-
pant), then within 60 days the participant may rollover
only the taxable earnings to another Roth 401(k) ac-
count.15 In short, the participant cannot rollover the
Roth 401(k) contributions themselves using a 60-day
rollover. Therefore, indirect 60-day rollovers of Roth
401(k) contributions can be a bad idea for tax purposes
because the distributed Roth 401(k) contributions no
longer earn tax-free income. Another Roth oddity is the
complicated carryover rules that relate to the five-year
holding period on Roth 401(k) rollovers. The five-year
holding period never carries over to a Roth IRA,16 and
the prior holding period only transfers to a Roth 401(k)
account when the rollover is completed as a direct roll-
over between two defined contribution plans.
Advent of Roth 401(k) Conversions
The Small Business Jobs Act of 2010 introduced in-
plan Roth 401(k) conversions (termed ‘‘in-plan roll-
overs’’ under IRS guidance) for distributions after Sept.
4 Treas. Reg. §§ 1.401(m)-1(a)(2) and 1.401(a)-13(d)(2).
5 Roth contributions are treated as elective deferrals under
26 U.S.C § 402(g)(3) and subject to the same annual maximum
limits as elective deferrals made to a 401(k) plan. See also 26
U.S.C. § 402A(a)(1), (c)(2); Treas. Reg. § 1.401(k)-1(f)(4) and
26 U.S.C. § 414(v)(1), (5).
6 Treas. Reg. § 1.401(k)-1(f)(4)(i).
8 26 U.S.C. § 402A(a)(1).
9 Id.; 26 U.S.C. § 402A(d).
10 26 U.S.C. § 402A(d); 26 U.S.C. § 408A(d)(2).
11 26 U.S.C. § 402A(d)(2)(B)(i); Treas. Reg. § 1.408A-6,
Q&A-2.
12 26 U.S.C. § 1.402(c)(9); Treas. Reg. § 1.402A-1, Q&A-
13 Treas. Reg. § 1.408A-6, Q&A-14.
14 Treas. Reg. § 1.402A-1, Q&A-5.
16 Treas. Reg. § 1.402A-1, Q&A-4(b)
4-1-14 COPYRIGHT  2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN
27, 2010.17 An in-plan Roth 401(k) conversion is the
conversion of a participant’s existing non-Roth account
balance into a Roth 401(k) account balance within the
sponsor’s plan. In other words, the conversion changes
the tax character of the participant’s non-Roth money
to Roth 401(k) money. In-plan Roth 401(k) conversions
originally were available for any of the participant’s
contributions in a defined contribution plan as long as
these amounts were both vested and otherwise eligible
for distribution to the participant.18
At the beginning of 2013, the American Taxpayer Re-
lief Act significantly relaxed the in-plan conversion
rules.19 Plan sponsors that permitted Roth 401(k) con-
tributions also could allow in-plan Roth 401(k) conver-
sions of account balances that were not immediately
distributable to the participant. Later guidance con-
firmed that these nondistributable balances still must
be vested to be eligible for an in-plan Roth 401(k) con-
Mechanics of Roth 401(k) Conversions
Congress’s purpose in expanding in-plan Roth con-
version opportunities was to raise revenue. Amounts
converted to Roth 401(k) contributions, other than tra-
ditional after-tax contributions, are subject to tax in the
year of conversion. Although in-plan Roth 401(k) con-
version amounts generally are subject to immediate
taxation, employers aren’t required to withhold income
tax on converted amounts.21 In this case, a participant
may face a large tax bill for the conversion year unless
the participant requests an increase in income tax with-
holding or makes estimated tax payments. The plan
sponsor reports an in-plan Roth 401(k) conversion on
Form 1099-R, which is the same form used for an actual
plan distribution. Participants report the Roth 401(k)
conversion as a retirement plan distribution on their
A participant can implement a Roth 401(k) conver-
sion without spousal consent.22 When a participant con-
verts a non-Roth balance to Roth 401(k) balance, any
distribution restrictions that applied before conversion
continue to apply after conversion.23 For example, dur-
ing employment a participant can withdraw pretax
401(k) contributions only due to hardship or attaining
age 59-1/2 and only if the plan allows for such in-service
withdrawals. These in-service withdrawal restrictions
will continue to apply to any pretax 401(k) contribu-
tions converted to Roth 401(k) contributions.
An in-plan Roth 401(k) conversion doesn’t trigger the
10 percent penalty tax that applies to early distributions
before age 59-1/2.24 However, if the converted Roth
401(k) amounts are distributed within five years of the
conversion year (other than as a rollover to another
Roth account or Roth IRA), then the participant may
have to pay the 10 percent penalty tax that would have
applied to the original conversion, which is known as
the ‘‘recapture’’ rule.25 This recapture rule for early dis-
tribution taxes is separate from the five-year holding
rule that relates to qualified Roth distributions dis-
cussed above, and the two different five-year rules cre-
ate confusion among participants and plan sponsors.
Issues With Roth 401(k) Conversions
As noted above, a plan sponsor must amend a 401(k)
plan to permit in-plan conversions. After the plan has
been amended to permit Roth 401(k) conversions, the
plan sponsor will need to create and administer a sepa-
rate Roth 401(k) account for participants who make
conversions but who don’t make other Roth 401(k) con-
tributions. For participants who already make Roth
401(k) contributions, the converted amounts could be
transferred to their existing Roth 401(k) accounts.
However, since prior distribution restrictions and tax
recapture rules still apply to converted Roth 401(k)
amounts, a plan sponsor may need to create more than
one Roth 401(k) account for a participant to ensure cor-
rect administration of distribution and tax rules.
To properly implement Roth 401(k) conversions, plan
sponsors should also update summary plan descrip-
tions, safe harbor notices (if applicable), enrollment
materials, and other participant communications to re-
flect the new in-plan Roth 401(k) conversion feature.
Also, if the feature isn’t available to all plan partici-
pants, plan sponsors should make sure that the conver-
sion feature doesn’t discriminate in favor of highly com-
pensated employees.26
Recent guidance provided plan sponsors clarity on
some outstanding issues relating to Roth conversions.27
s First, plan sponsors don’t need to distribute the
special tax notice under tax code Section 402(f) when a
participant converts a nondistributable balance to a
Roth 401(k) balance.28
s Second, plan sponsors can restrict the type of par-
ticipant contributions eligible for, and the frequency of,
in-plan Roth conversions, which can simplify adminis-
tration of Roth accounts considerably. For example, a
plan sponsor could limit in-plan Roth conversions to
only pretax 401(k) deferrals or permit only one Roth
401(k) conversion per participant per year.29
s Third, plan sponsors can discontinue an in-plan
Roth conversion feature at any time without violating
the tax code’s prohibition on elimination of protected
benefits, as long as the timing of the plan amendment
doesn’t discriminate against nonhighly compensated
employees.30 Thus, plan sponsors need not make in-
plan Roth conversions a permanent feature of their
The new guidance also provided plan sponsors a spe-
cial one-time extension on amendments to permit Roth
17 Section 2112(a) of the Small Business Jobs Act of 2010,
Pub. L. No. 111-240 (Sept. 27, 2010) added 26 U.S.C.
§ 402A(c)(4), effective for distributions made after Sept. 27,
18 IRS Notice 2010-84, 2010-51 I.R.B. 872 (Nov. 29, 2010),
19 Section 902 of the ATRA added 26 U.S.C. 402A(c)(4)(E),
effective for transfers made after Dec. 31, 2012.
20 IRS Notice 2013-74, 2013-52 I.R.B. 819 (Dec. 11, 2013),
Q&A-1.
21 IRS Notice 2010-84, Q&A-8.
22 IRS Notice 2010-84, Q&A-3.
23 IRS Notice 2013-74, Q&A-3.
24 26 U.S.C. § 402A(c)(4)(ii); Treas. Reg. § 1.408A-4, Q&A-7.
25 IRS Notice 2010-84, Q&A-12.
26 IRS Notice 2013-74, Q&A-6.
27 IRS Notice 2013-74. In addition to the items discussed
above, IRS Notice 2013-74 provides further guidance on Roth
pre-conversion amounts invested in employer stock for pur-
poses of determining eligibility for the special tax rules on net
unrealized appreciation after Roth conversion.
28 Id., Q&A-1.
29 Id., Q&A-6.
30 Id., Q&A-7.
ISSN BNA 4-1-14
401(k) deferrals, incoming Roth 401(k) rollovers or in-
plan Roth 401(k) conversions.31 Although generally the
IRS requires a plan sponsor to amend a defined contri-
bution plan by the end of the plan year in which Roth
401(k) features are added, the IRS has extended the
deadline for adopting these amendments to Dec. 31,
2014, or the last day of the first plan year in which the
amendment is effective, whichever is later. Plan spon-
sors who permitted Roth 401(k) deferrals, incoming
Roth 401(k) rollovers or in-plan Roth 401(k) conver-
sions in 2013 now have more time to adopt plan amend-
ments that reflect these changes. Similarly, safe harbor
plan sponsors may implement midyear in-plan Roth
401(k) conversions of otherwise nondistributable
amounts until Dec. 31, 2014, and may adopt Roth
amendments until Dec. 31, 2014. After Dec. 31, 2014,
defined contribution plan sponsors must adopt amend-
ments by plan year-end to reflect any of these Roth
401(k) features implemented during such year, and a
safe harbor plan sponsor can implement a Roth 401(k)
conversion feature only at the beginning of a plan year.
With the expanded opportunities to convert defined
contribution balances to Roth balances, we anticipate
the continued growth of Roth 401(k) balances as a pro-
portion of overall 401(k) plan balances. This growth
may be particularly true for younger workers in low
income-tax brackets, who may have a long time horizon
during which tax-free earnings can accumulate in Roth
401(k) accounts and who may currently pay taxes at
lower tax rates than expected at retirement. Given the
current trends, we recommend that plan sponsors con-
sider implementing or expanding a Roth 401(k) feature,
but with a careful eye on the complex legal, tax and ad-
ministrative challenges involved in implementing Roth
401(k) contributions and in permitting Roth 401(k) con-
versions.31 Id., Q&A-5.
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