Whenever I meet with a financial planning client, the subject of the Roth IRA comes up. By way of a refresher, unlike a traditional IRA, contributions to Roth IRAs are nondeductible.
For 2013, the maximum that can be contributed to a traditional and Roth IRA is the smaller of $5,500 ($6,000 if you are age 50 or older) or your taxable compensation for the year, subject to modified adjusted gross income limits.
Nonworking spouses can also make Roth contributions as long as their spouse has earned income.
The Roth has many advantages over the traditional IRA including that the Roth grows tax-free while the traditional IRA grows tax-deferred; Roth’s have no age requirements for when a taxpayer must start taking withdrawals or stop making contributions.
Deductible contributions to a traditional IRA are generally the better choice for taxpayers expecting to be in a lower tax marginal tax bracket when funds are withdrawn. Deductible IRA contributions may also be the better choice for a taxpayer who needs the funds resulting from the tax savings to make the contribution.
Many higher earning taxpayers who participate in an employer plan may find themselves locked out of the IRA option due to income limitations.
The In-plan rollover
The American Taxpayer Relief Act (ATRA) expanded the opportunity for participants to convert existing tax deferred money in qualified plans such as a 401(k) plan to Roth accounts in the same plan after December 31, 2012.
Prior to the new law, the in-plan Roth rollover conversion feature allowed participants to make in-plan rollovers for distributable amounts, such as separation from service (termination), in-service distributions, death or disability. The new law permits an in-plan Roth conversion without having a distributable event. The law also permits rollover amounts from the pretax, matching or after-tax accounts to a Roth account within the same plan.
Even though the IRS treats the rollover as a taxable distribution from a tax-deferred account, by paying tax on the conversion year, participants can potentially save future taxes on the principal amount. Future investment gains are distributed income tax-free! Bear in mind that these types of conversions don’t allow participants to change their mind after the conversions are made.
Recharacterizations are not allowed.
ATRA also reduced individual tax consequences, such as a 10% early distribution penalty, by changing the requirement that they have a distributable event (such as reaching age 59 1/2) to make an in-plan Roth rollover. Thus, plan sponsors no longer will have to ascertain if the participant is eligible for an in-service distribution under their plan’s terms before a rollover.
What plans need to do
When offering in-plan Roth rollovers, the plan must allow Roth contributions; it can’t permit the conversion unless it already allows them. Employers don’t have to offer this option, but if they elect to do so they must make a plan amendment by the end of the year in which the amendment is effective.
As under prior law, plans just make eligibility for the in-plan Roth rollovers available to surviving spouse beneficiaries and alternate payees who are current or former spouses. For now, the IRS has not published final guidance for plan amendments.
Roth distribution considerations
While ATRA focused on rollovers from existing tax-deferred money in qualified plans, to Roth accounts in the same plan, don’t forget to communicate Roth tax consequences to participants. A Roth distribution is tax-exempt if it satisfies certain requirements.
For example, the Roth distribution must be held for five years and be made after an individual reaches 59 1/2, is disabled or dies. If any portion of the taxable amount is distributed within a five-year period (which begins on the first day of the tax year in which the rollover was made), it is subject to the 10% additional penalty on early distributions unless the participant is age 59 1/2 or older.
Get ready to offer rollovers
Employers drafting the in-plan Roth rollover should work with their employee benefits advisor to coordinate account administration with participant communications, recordkeeping and nondiscrimination testing. Also, be prepared to clearly discuss the new Roth rollover option to participants.
The RMD for other than a Roth
For employers sponsoring qualified plans, it is crucial to identify participants over 70 1/2 because of required minimum distributions.
The year the participants turn age 70 1/2, they can either take their RMD by December 31 or defer it until April 1 of the following year. If they choose to do the latter, they must take their RMD by December 31 of that same year. Participants who are considered 5% owners must take the RMD each year, regardless of their employment status. However, participants that are not 5% owners, but are still employed, can defer their first RMD until their employment terminates.
Failure to follow the rules can subject the participant to a 50% excise tax. If it is discovered that a plan has not distributed the RMD timely or at all, you can use the IRS’s Employer Plans Compliance Resolution System to correct the errors and avoid plan disqualification. If a participant over 70 1/2 wants to rollover the RMD to another qualified plan or IRA, the plan must first calculate and pay the RMD. Amounts withdrawn above the RMD are eligible for rollover.