Episode 8: Overview of In-Plan Roth 401(k) Conversions

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Audio Transcript: 

James Isaac: Welcome to Winston’s Benefits Blast podcast. I'm James Isaac, an employee benefits attorney at Winston and Strawn, and I’m joined today by Nancy Gerrie, co-chair of the Employee Benefits and Executive Compensation Group here at Winston. During this episode, we will talk about Roth 401(k) conversions inside a 401(k) plan, so-called “in-plan Roth conversions.” So Nancy, please tell our listeners why we are talking about these conversions today? Is this a new option?

Nancy Gerrie: Thanks James. We picked this as a topic today because we’ve been getting more interest from some of our plan sponsor clients about adopting a Roth conversion feature in their 401(k) plan. And I think this increased interest may be due to a couple of factors. Number one, I think some individuals may think that their current tax situation will be more favorable for them than their tax situation if a new political party were to take power. So they’re thinking more about putting funds into Roth options while they think their tax bracket is lower, theoretically.

Nancy Gerrie: Number two, I think people are getting more comfortable with the whole idea of Roths. Roth IRA accounts first started in 1997 and when they first were introduced a lot of practitioners said that Roth was too good a deal and the government was going to kill off the Roth concept after a few years, but that has not happened. Fast forward to now, Roths have been around for 22 years and it seems like at this point it would be very difficult for lawmakers to make such a drastic change to a very popular program. And then, of course, Roth IRAs led to Roth 401(k) features, and as 401(k) plan sponsors look for ways to offer new benefits to their employees in all their plan designs, the Roth 401(k) in-plan conversion option is getting some attention again too.

James Isaac: Great. So what is exactly an in-plan Roth conversion?

Nancy Gerrie: Well, as we were saying before, a number of plans now allow participants to make Roth after-tax contributions to their accounts. But what about all the 401(k) and other pre-tax funds that built up in that plan before Roth? Could we convert some of those pre-tax funds built up in our plan accounts to a Roth? And the IRS said yes to that question in 2010, but it was more of a halfway yes than what we were hoping for. So the IRS published guidance saying that plans could allow these in-plan Roth conversions where certain amounts within the 401(k) plan could be converted to Roth and still stay in the plan. And that way the participant can increase the percentage of his retirement savings in Roth with all of the benefits of Roth. For example, no taxation of the converted amount and no taxation on future earnings as long as the amount is withdrawn in compliance with the Roth distribution options, which are age 59-1/2 and five years of Roth earnings.

Nancy Gerrie: Of course the participant would have to pay taxes on the converted amounts in the year of the conversion. So although the 2010 option was helpful, its usefulness was kind of limited because the IRS limited its rules so that only in-plan accounts that could be converted to Roth were those that were “otherwise distributable.” So this classification really doesn’t cover very many account tapes in the 401(k) plan while the person is still working. So in most cases, the only conversions that were being done were by people who are already age 59-1/2, or sometimes doing a conversion using traditional after-tax money in the 401(k) plan and converting sometimes each pay period. And of course, at that point, the IRS was happy to encourage people to take money into income early to increase their revenues.

Nancy Gerrie: But for most everyone else, these 2010 conversions weren't particularly useful. But in 2013, lawmakers were grappling with the fiscal cliff (remember the fiscal cliff?) and looking for revenue again. They decided to allow plans to permit participants to convert all of their in-plan account balances to Roth conversion, even if the amounts were not “immediately distributable.” So the lawmakers thought they would get a spike in tax revenues as a result of expanding this Roth option. And so that’s why the change was implemented in 2013. Of course, again, employees who exercise this option in their plan have to pay taxes on the amount converted, but then their earnings after that date are tax-free.

Nancy Gerrie: So we now have in-plan Roth conversion options that allow a plan to convert any amounts permitted by the plan, 401(k) after-tax, employer match, and non-elective contributions at the participant’s selection to a Roth. And they don’t have to wait until those underlying funds are “immediately distributable.”

James Isaac: Nancy, I've noticed that some third-party recordkeepers can only administer the 2010 version, the first version of the Roth conversion that you just mentioned, and they can’t accommodate this broader and more recent 2013 option that you mentioned. Have you seen this?

Nancy Gerrie: Yes, I have. I noticed that there were some problems with some of the big recordkeepers a few years ago accommodating the 2013 version. It’s because they have to still treat those amounts as not distributable for other purposes in the plan. So sometimes they had to set up a whole number of new account sources, so it was frustrating at that point. But it does seem that most of the major players now can handle the 2013 version. But we do advise any plans sponsor who’s considering adopting a Roth conversion feature to contact their third-party recordkeeper as soon as possible to determine what they can and can't administer.

James Isaac: That makes sense. You know, one other thing that we should probably touch on here for a minute is the 10% excise tax due, or I should say that’s generally due if you distribute 401(k) funds while someone is still working, does that apply to a Roth in-plan conversion?

Nancy Gerrie: That’s a great question, James. Usually a 10% excise tax would apply to an amount that’s distributed out of an IRA or a 401(k) plan if that participants under age 59-1/2. But the good news for in-plan Roth conversions is that the IRS does not treat the amount converted to Roth inside the plan as being distributed for purposes of that 10% excise tax. So that means no 10% excise tax will apply to in-plan Roth conversions, even if the participant is under age 59-1/2. And that makes sense because the money is never actually leaving the plan; it’s just changing its tax status.

James Isaac: Great. So that’s good news. One other thing maybe for our plan sponsors to consider. If they want to add the in-plan Roth conversion feature to the plan, are they going to be locked into maintaining that feature in the plan forever? Or would they still have the option of someday removing it from the plan if they wanted to?

Nancy Gerrie: Actually, that’s good news here too. The plan sponsor is not locked in to maintaining the feature indefinitely and they could ultimately decide that they want to remove that in-plan Roth conversion feature at a later date. Although, there’s so much upfront legwork that goes along with adding the feature in the first place, and certain non-discrimination considerations that may be relevant when you’re thinking about removing it, that the plan sponsors should be careful when deciding whether to add the feature to its plan in the first place.

James Isaac: Great. Okay. Well with that, maybe we can talk about a couple of big Winston takeaways from today’s discussion.

Takeaway number one: Consider including an in-plan Roth conversion feature in your plan. It can be very interesting to younger employees and some older employees over age 59-1/2.

Takeaway number two: If you are thinking about adopting the conversion feature as Nancy was just talking about, be sure and check with your recordkeeper to confirm that they can administer the aspects of the program that you think would be most beneficial to your employee base.

Nancy Gerrie: Thank you for joining us today.

James Isaac: Thank you Nancy and thank you to everyone for listening to another edition of our Benefits Blast Podcast. Stay tuned to future episodes for more insights on the latest legislative, regulatory, and practical developments concerning employee benefits and executive compensation. Also, please be sure to check out our Benefits Blast blogs for updates on the latest legal developments in the employee benefits area. You can reach that by going to winston.com and clicking on the blogs link at the top of the page. Thanks again so much.