Understanding in-plan Roth conversions 

The Roth in-plan conversion or Roth in-plan rollover can be an excellent tax-saving strategy if done correctly. But what is it exactly?  

This differs slightly from other Roth conversions in that it is a retirement planning move that lets individuals convert a portion or all their pre-tax assets into Roth assets. Roth in-plan conversions give them a chance to create retirement income that is tax-free and can help manage their future tax liabilities.  

How do in-plan Roth conversions work? What sort of distributions can it roll over?  

In this article, InvestmentNews discusses the answers to those questions and more about Roth in-plan conversions.  

What is a Roth in-plan conversion? 

This is also known as the 401(k) in-plan Roth conversion or the in-plan Roth rollover (IRR), which is a relatively new plan feature-slash-financial strategy.  

The in-plan Roth conversion allows account owners to transfer non-Roth assets in their 401(k) plan, 403(b) plan, or governmental 457(b) plan to a Roth account contained within the same plan.  

The main advantage of the in-Plan Roth conversion is that it lets the converted money grow tax-free (instead of tax-deferred) for years, even decades. The money in this conversion continues to grow if the account owner follows their employer’s Roth in-plan conversion rules.  

What are the requirements for an employer to offer an in-plan Roth conversion?  

For an employer to offer this type of conversion, they must meet these requirements:  

• the employer must allow its plan participants to defer their Roth contributions by choice 
• if an employer does not already offer a contribution program to a designated Roth account, they must amend their plan document to add a provision that allows the conversions 
• an employer should also accept or amend the plan to accept (even though the IRS does not explicitly say so) designated Roth rollover contributions from other plans before it allows in-plan Roth conversions 

There are limits to how much plan participants can contribute to their 401(k)s and other plans, the amounts of which vary in every tax year. 

Who can do an in-plan Roth conversion?  

The plan participant, surviving spouse beneficiary, or a QDRO recipient (spouse or former spouse of the account owner) of a: 

• 401(k) plan  
• 403(b) plan 
• 457(b) plan  

Not all employers offer the in-plan Roth conversion; this must be a feature offered in the plan. Some employers even have an auto-convert/auto-rollover feature in their plan.  

When an employer decides to offer the in-plan conversion, they are obliged to notify plan participants. This notice can be provided via the company’s Summary of Material Modifications (SMM) or the Summary Plan Description (SPD).  

IRS Notice 2013-74 states that the 402(f) notice requirements do not apply to direct rollovers unless the individual is eligible to receive a distribution under the plan. All indirect rollovers follow the normal distribution notice requirements, including spousal consent, when appropriate. 

You can check out this video that talks about the importance of reading the SPD or Summary Plan Description. This lets us know whether an employer offers the In-plan Roth conversion. Moreover, it sheds light on why not many plan participants are even aware of its existence. Watch for more on what you need to know about this conversion:  

What types of distributions can my client roll over in a Roth in-plan conversion?  

They may roll over only the eligible rollover distributions in an in-plan Roth conversion. In general, an eligible rollover distribution is any distribution except for the following:  

• hardship distributions 
• Required Minimum Distributions (RMDs) 
• excess contributions, excess deferrals, or other corrective distributions and any income on them  
• a loan treated as a distribution that didn’t meet all loan requirements when made or later, unless the accrued benefits were offset to repay the loan  
• dividends earned on shares of employer securities 

When would an in-Plan Roth conversion be helpful? 

As with other wealth management strategies, an in-plan Roth conversion is beneficial to certain types of investors in certain situations, such as:  

1. When investors are still young and in a lower tax bracket.  

In this case, doing an in-plan Roth or several conversions would benefit them immensely. This allows the account owner to accumulate decades worth of earnings for themselves and their family. This is also an excellent way to lower their tax liability if they predict that they will have a higher income, and therefore be taxed at a higher rate in the future.  

Making in-plan Roth conversions while an investor’s income is still taxed at the ordinary tax rate is a good strategy. This means they’ll pay much less in taxes now, rather than pay higher conversion taxes later.  

Remember the five-year rule: investors must leave the conversions untouched in the Roth account to avoid the penalty for early withdrawals.  

2. If they have medical expenses.  

In-plan Roth conversions are beneficial to investors who have costly medical expenses. That’s because these expenses can be listed as deductions that offset the taxes for the year that they do the conversion.  

3. They are high net worth individuals.  

High-income and high-net-worth investors who don’t think they will rely on their retirement savings can benefit from an in-plan Roth conversion. Doing this can enable them to grow the money in the account tax-free for many years, if they stick to the rules. And even when they are past retirement age, they may continue to make contributions to the Roth account. What is the point of a conversion in this case? It’s a great strategy for leaving a significant inheritance to their children.  

4. The investor is moving to a state with higher taxes.  

This is another way of getting higher taxes, but only in terms of moving location and not getting bumped into a higher tax bracket due to increased income. If an investor retires to another state that has higher income taxes, then it’s advisable to do an in-plan Roth conversion to lower their tax liability.

5. Their investment portfolio has experienced a downturn. 

Investors whose retirement portfolios have taken a hit from a decline in the markets should consider an in-plan Roth conversion. The lower tax liability from such a move could cushion their losses and their investments can resume growing tax-free when the markets stabilize.  

When would an in-Plan conversion not be helpful? 

On the other hand, there are situations where an in-plan Roth conversion may not be a wise strategy. Here are some instances where investors should avoid the conversion: 

1. When investors don’t have the extra money to pay for the conversion tax. 

In this case, an in-plan Roth conversion would be ill-advised. The conversion may trigger a hefty tax bill, and using money in the conversion to pay the tax undermines the potential gains. 

This could be worse if the tax bill was so significant that using money in the conversion would greatly shrink the account.  

Such a scenario may force the investor to sell another asset, which might even push them into a higher income tax bracket, adding even more income tax. In this case, the investor is better off postponing the conversion until they have extra money to cover the taxes. 

2. They are high-income earners who are close to retirement.  

A conversion of this sort would also not make good sense for those with high incomes.  

Investors should first compare their current and anticipated tax bracket by the time they retire. For this, they should consider all their retirement income sources. They should only pursue an in-plan conversion if they find that will be placed at a higher tax bracket.  

Tax implications of an in-plan Roth conversion 

This type of Roth conversion turns pre-tax assets into after-tax Roth assets, so there is a corresponding income tax on the pre-tax contributions and any earnings on the converted assets. However, the income taxes are not incurred at the time of the conversion.  

It’s possible to trigger a sizable tax bill (both state and federal) for the tax year of this conversion. It’s advisable to prepare extra tax money from another source. 

A Roth conversion of this sort may also incur quarterly tax payments. Come tax time, those who make the conversion will receive Form 1099-R listing the value of any previously made Roth conversions.  

In general:  

• If the plan holder converts pre-tax contributions: they owe taxes on the contributions, as well as any investment earnings generated before the conversion date.  
• If the plan holder converted after-tax contributions: they owe taxes on any investment earnings generated before the conversion date. In either case, income taxes are not withheld at the time of conversion. 

The five-year rule 

As this is a form of Roth conversion, remember that the five-year rule still applies. To refresh your memory, there is a penalty if the Roth assets are withdrawn within a five-year period from the conversion. You may be surprised to know how many investors get confused by this rule.  

This rule is in place to prevent plan participants from processing a conversion, then taking a distribution that’s tax-free and penalty-free immediately from their account.  

The penalty can consist of a 10% federal penalty tax on the part of the withdrawal that resulted from the conversion. Apart from this penalty, the account owner may also have to pay ordinary income tax, unless they are already 59½ of age or older.  

How are in-Plan Roth conversions processed? 

There are two ways: 

1. Direct Rollover – The assets considered eligible for rollover are transferred directly to the designated Roth account from a non-Roth account under the same plan.  

2. Indirect Rollover – The assets eligible for rollover are distributed to the individual plan holder. In this instance, the plan holder is then given 60 days within which to roll back the assets into the same plan.    

Is there a limit to conversions on an in-plan Roth conversion? 

No, there is no limit. The plan participants can convert as much as they wish.  

How often can I convert pre‐tax savings to Roth?   

While the amounts that plan participants can convert are unlimited, in-plan Roth conversions with pre-tax savings can only be done once a year.  

When can an investor withdraw the converted Roth amounts? 

When contributions are converted, the investor/account owner can withdraw them when they are considered eligible to do so, as set forth by the terms of the plan. In general, withdrawals are allowed only if the plan participant:  

• has reached the age of 59½ 

• receives withdrawals as severance 
• becomes disabled 
• passes away 

The five‐year rule also applies to tax‐free withdrawals of Roth 403(b) earnings from retirement plans. The five‐year period begins at the start of the year in which a Roth in-plan conversion was made, or the first Roth 403(b) salary deferral contributions, if this was earlier. 

As a financial advisor, it is your duty to make sure investors have all the information they need about Roth conversions. This is especially true for in-plan Roth conversions, as some plan participants may not be aware of its existence – even if the feature has been around for over a decade.  

That said, some employers offer an auto-convert feature within their plan. You can advise or assist your clients to ask to set it up so after-tax contributions are automatically converted to their Roth regularly.  

Before implementing the conversions, crunch the numbers and help them time and strategize the Roth conversions. Remember, your client relies on you to come up with an optimal strategy to suit their financial situation, retirement plans, and financial goals.  

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