The American Taxpayer Relief Act of 2012 (the "fiscal cliff" bill) allows employers to amend 401(k), 403(b) and governmental 457(b) plans to permit participants to convert pre-tax account balances to Roth account balances.  Previously, such conversions were permitted only when the pre-tax amounts could be distributed.

Background

On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012.  The new law permits 401(k), 403(b) and governmental 457(b) plan sponsors to amend their plans to permit any amount under the plan to be converted to a Roth amount within the plan, even if the amount is not otherwise distributable.  Converted amounts are treated as distributions and taxable in the year of conversion.  The new law is effective January 1, 2013, but permits conversions of balances accumulated before 2013.

Prior to the new law, 401(k), 403(b) and governmental 457(b) plan sponsors could amend their plans to permit vested account balances to be converted to Roth amounts within the plan, but only if those amounts were otherwise distributable under the terms of the plan and qualified as eligible rollover distributions.  This generally meant amounts were convertible only upon the participant’s severance from employment, death, disability or attainment of age 59½ or, in the case of profit sharing or matching contributions, upon a stated age, stated event or fixed number of years, although traditional after-tax and rollover contributions and their earnings are generally freely distributable at any time.  As under the new law, converted amounts were generally treated as distributions and taxable in the year of conversion (subject to a special rule for 2010).  

A more in-depth discussion of the prior law can be viewed here.

Expansion of In-Plan Roth Conversions

Now, 401(k), 403(b) and governmental 457(b) plan sponsors may permit participants to make in-plan Roth conversions for any amounts held in the plan, regardless of whether they are otherwise distributable.  A plan may (but is not required to) permit in-plan Roth conversions only if the plan is a 401(k), 403(b) or governmental 457(b) plan that has a Roth elective deferral arrangement.  So, for example, a plan that consists only of profit sharing contributions would not be eligible to offer in-plan Roth conversions.  If an eligible plan does not already have a Roth feature, it must add one to the plan before participants can be permitted to make in-plan Roth conversions.

Moreover,  plans that currently permit Roth contributions must be amended if the employer wants to permit amounts that are not otherwise distributable to be converted to Roth amounts.  As noted above, once the plan is amended, employees may convert amounts already in the plan to Roth amounts.

Once the plan has been amended to permit amounts that are not otherwise distributable to be converted to Roth amounts, the plan sponsor will need to set up and administer separate Roth accounts for participants who make conversions and don’t already have them.  For participants who already have Roth accounts, the converted amounts would be transferred to the Roth accounts.

Because the American Taxpayer Relief Act of 2012 was signed into law so recently, there is not yet any Internal Revenue Service (IRS) guidance on questions employers may have on establishing or administering this expansion of in-plan Roth conversions.  Similarly, no “model” form of plan amendment has been circulated by the IRS.

Benefits to Participants

The ability to convert plan assets into Roth assets may be popular with plan participants because they can choose to convert plan assets into Roth assets and later take a tax-free distribution, provided the participant meets the requirements for a qualified Roth distribution.  Participants who are unsure about future tax rates or their future tax bracket can hedge their risks by converting some retirement plan assets into Roth assets and maintaining other assets as traditional pre-tax assets.

Conversion may be particularly appealing for participants who expect their tax rate to be higher when amounts are distributed, as well as those who are younger and whose accounts will have more time to grow after they are converted. 

Converted amounts are not subject to the 10 percent early distribution tax under Section 72(t) of the Internal Revenue Code (generally applicable to distributions to participants under age 59½ that are not rolled over to an IRA or another qualified employer plan).