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Roth IRAs - Part 2: Plan Rollovers to a Roth IRA 1/19/2010
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This is the second in a series of Technical Updates, covering Roth IRA issues, including 2010 law changes, plan to Roth IRA rollovers, Roth IRA conversions, recharacterizations and reconversions, and taxation issues associated with Roth IRA transactions. This Part 2 discusses the rules relating to pre-tax plan rollovers to a Roth IRA.

Q-1: Can I “convert" to a Roth IRA an eligible rollover distribution from a non-Roth account in a qualified plan (e.g., profit sharing or 401(k) plan)?

Yes. As a result of the Pension Protection Act of 2006, for distributions after December 31, 2007, Congress expanded the opportunity to convert to a Roth IRA by permitting a rollover from an “eligible retirement plan" to a Roth IRA. This eliminated the intermediate step of rolling over to a traditional IRA, and then converting the traditional IRA to a Roth IRA. Qualified plans, such as 401(k) or profit sharing plans, 403(a) annuity plans, 403(b) plans, and governmental 457(b) plans are all “eligible retirement plans" from which a rollover is possible. As discussed in Q&A-1 of Part 1 of this series, the income limitation that prevented many taxpayers from doing such a conversion in 2008 or 2009 no longer applies beginning January 1, 2010.

While a rollover of a non-Roth plan account from an eligible retirement plan to a Roth IRA technically is a qualified rollover contribution to the Roth IRA, the tax consequences are the same as a rollover to a traditional IRA followed immediately by a conversion to a Roth IRA (but without aggregating the IRA with the taxpayer’s other IRAs). For purposes of simplicity, we refer to this transaction (i.e., rollover of a non-Roth plan account to a Roth IRA) as a “conversion."

Q-2: In order to convert my plan account to a Roth IRA, do I have to make a direct rollover from the plan to the IRA?

No. A taxpayer may accomplish the conversion from a plan account to a Roth IRA either by a direct rollover from the plan to the IRA or by a 60-day rollover, in which the taxpayer receives the distribution and rolls over the distribution to a Roth IRA within 60 days of receipt.

If the taxpayer-participant takes a distribution, the plan will withhold 20% of the distribution as income tax. However, the taxpayer still can roll over the gross distribution (within the 60-day period), but will need to replace the withheld amount from other sources to roll over the entire distribution amount.

Q-3: Can I roll over from my Roth 401(k) (or Roth 403(b)) plan account to a Roth IRA? What are the tax consequences of the rollover?

Yes. A taxpayer may roll over a Roth 401(k) (or Roth 403(b)) plan distribution to a Roth IRA. (This rule is clear after a “clarification" included in the Worker, Retiree, and Employer Recovery Act of 2008 (“WRERA").) There are no tax consequences on the rollover, regardless of whether or not the distribution is a “qualified" distribution. A later Tech Update in this Roth IRA series will discuss the definition of a qualified distribution and the tax consequences of taking a qualified or nonqualified distribution.

Q-4: If I wish to convert my non-Roth plan account to a Roth IRA to take advantage of the 2010 law change, must my employer permit me to take a distribution without regard to the plan terms?

No. In order to receive a plan distribution, a participant must have a “distributable event" such as separation from service or attaining normal retirement age. Although a profit sharing plan may have liberal in-service provisions, a plan need not permit in-service distributions. A 401(k) plan has more limited distribution events, and generally may not distribute before the participant’s reaching age 59½ or severing from employment. A participant should consult the plan administrator or review the plan document or the summary plan distribution to determine whether he/she is eligible for a distribution. If you otherwise are not eligible for a plan distribution, the potential of rolling over to a Roth IRA does not by itself qualify you for a plan distribution.

Q-5: If I am receiving an eligible rollover distribution from a plan, must the employer permit me to elect a direct rollover to a Roth IRA?

Yes. If a participant is entitled to a distribution, and the distribution is an eligible rollover distribution (i.e., is not a required distribution, a hardship distribution, or certain other categories not eligible for rollover), the plan must permit the participant to elect a direct rollover to a Roth IRA (except for certain small distributions of less than $200).

Q-6: Can I convert a non-Roth plan account that includes after-tax dollars?

Yes. As in a conversion of a traditional IRA to a Roth IRA (see Q&A-3 of Part 1), a taxpayer who converts a non-Roth plan account to a Roth IRA must include in income only the taxable portion of the distribution. The taxable portion is includible in income in the year of the conversion, subject to the special 2010 rule providing for taxation of a 2010 conversion in 2011 and 2012 (see Q&A-4 of Part 1).

Example #1. On June 1, 2010, John takes a $20,000 eligible rollover distribution from his profit sharing plan, and directly rolls the distribution to a Roth IRA. The distribution consists of $4,000 basis and $16,000 taxable income. For purposes of determining his income tax liability, John only includes in gross income $16,000, the taxable portion, of the $20,000 distribution.

Q-7: If I take a distribution that includes employer securities, or if I qualify for income averaging on the distribution, and I roll over the distribution to a Roth IRA, can I take advantage of either of these special tax rules to reduce my tax bill on the conversion?

No. The IRS treats the conversion as if the taxpayer rolled over the distribution to a traditional IRA, and then converted the IRA to a Roth IRA. Upon a rollover of a distribution to an IRA, a taxpayer entitled to special tax treatment of a lump sum distribution or of net unrealized appreciation on a distribution of employer securities loses the benefit of those special tax rules. Although these special rules only affect a small number of distributions, taxpayers eligible for such treatment should consider the loss of potential tax benefits in making the decision to roll over the distribution to a Roth IRA.

Q-8: May a non-spouse beneficiary convert a death benefit distribution from a non-Roth account to a Roth IRA?

Yes. Of course, having to include in income the taxable portion of the distribution at the time of the conversion may be a disincentive for the non-spouse death beneficiary to convert. However, converting may be beneficial to a young beneficiary who will receive the benefits over a long life expectancy and is able to take advantage of tax-free distribution of the earnings of a qualified distribution from the Roth IRA. The beneficiary should consider carefully the effect of the conversion and immediate income inclusion on the special deduction for income in respect of a decedent and the limitations on itemized deductions.

Q-9: May a surviving spouse beneficiary convert a death benefit distribution from a non-Roth account to a Roth IRA?

Yes. A surviving spouse rolling over to a Roth IRA may elect either to establish the Roth IRA in the name of the decedent, with the surviving spouse as beneficiary, and continue to take death distributions from the IRA, or to treat the Roth IRA as his/her own.

We will discuss the Roth conversion process at the Advanced Pension Conference. In addition, Roth IRAs, conversion and related IRA issues will be the subject of ERISA Newsletter 2010-1. We also have added Roth IRA conversion and recharacterization forms to ERISA Forms. The ERISA Newsletter and ERISA Forms are part of The Pension Library.

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