Law creates more options for Roth rollovers

The Small Business Jobs Act of 2010 includes a provision that allows certain 401(k) and 403(b) participants to convert their plan funds to a Roth 401(k) or Roth 403(b) within the plan.

Not all employees are eligible, though. The new provision was effective the day the law was enacted.

Participants in 401(k) and 403(b) plans who make rollovers of their plan assets into designated Roth 401(k) or Roth 403(b) accounts will owe income tax on pre-tax funds converted. Plan conversions in tax year 2010 will be eligible for the same tax option as individual retirement account conversions made this year to a Roth IRA.

Clients will be able to split the income from the conversion equally over 2011 and 2012 or they can opt to include all of the income from the conversion this year.

Beginning next year, the new law allows Section 457 plans to include a Roth 457 option.

The law, however, isn’t quite the opportunity it might seem to be at first glance. There are three hurdles that your clients must pass in order to take advantage of this provision, and even then, it might not pay, because many clients who want to convert still may be better off doing it outside the plan.

For starters, your client’s 401(k) or 403(b) has to offer a designated Roth account as an option. That will exclude a good portion of your clients.

If your client’s plan has a Roth feature, then it is on to the next obstacle.

Will the plan allow an in-plan conversion? The Small Business Jobs Act allows plans to adopt such a provision, but it doesn’t require them to do so.

How many employers will add this option? That remains to be seen, but if history is any indicator, the additional record keeping required, procedures to be developed and the training required to address these changes will cause most plans to hesitate to adopt this option.

The one bright spot for clients is that if their plan does decide to add the in-plan Roth conversion option, the Small Business Jobs Act allows plan participants to act on the option immediately, as long as the plan later amends its language to reflect the change.

On to the final hurdle: Is your client eligible to take a distribution from the plan? Clients can’t simply move money from their regular contributions/earnings/employer matches whenever they want.

In order to convert their non-Roth funds, they will have to be eligible to take a distribution from the plan. In most cases, that probably means that your client has separated from service with the company.

Some companies have in-service distribution provisions that allow clients to access plan funds while they are still working. If your client’s 401(k) offers such a provision, it could allow them to make a conversion of their funds at the plan level while they are still working.

Regardless of how your clients have access to funds, though, if they can convert at the plan level, they generally could take the same money and roll it into an IRA or convert it to a Roth IRA.

That prompts the question: Which is more advantageous, a Roth IRA or designated Roth account at the 401(k) plan?

Although the new law allows clients to convert their 401(k) assets to designated Roth accounts at the plan level, in most cases, the better option for a client will be a Roth IRA.

The plan level Roth conversion allowed under the new law provides clients with some additional Roth options, but there is at least one alarming shortfall. There is no mechanism in place to re-characterize conversions made to designated Roth accounts.

This would provide clients with an incentive to convert to Roth IRAs instead of designated Roth accounts.

What if your client realized that he or she didn’t have the money to pay for the conversion after all? Or what if the client’s designated Roth account went down in value after conversion?

Wouldn’t the client want the flexibility to “undo” that transaction? If the answer is yes, then a conversion to a Roth IRA may be a better option.

Although part of the reason for this legislation was to prevent leakage from company plans, the lack of a re-characterization provision will likely dampen its effectiveness. Most of your clients who want to convert will fare better converting to a Roth IRA instead of an in-plan Roth 401(k).

Ed Slott, a certified public accountant, created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

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