Needed IRS Roth and ATRA Guidance

Whoever coined the phrase “the devil is in the details,” could easily relate to the uncertainty now facing the retirement industry following enactment of the American Taxpayer Relief Act of 2012 (ATRA).  Very few of ATRA’s provisions deal with retirement, but one issue is single-handedly making up in complexity and mystery what ATRA’s retirement dimensions lack in number.  Specifically Section 902, which allows pre-tax assets in certain employer-sponsored retirement plans to be converted to Roth status at any time, not just when they are distributable.  For those who may need reminding—and similar to Roth IRAs—the benefit of Roth-type assets in an employer plan is that they can generate tax-free earnings.

The Small Business Jobs Act of 2010 (SBJA), made it possible to convert pre-tax plan assets to Roth assets.  That legislation permitted a participant to convert pre-tax funds into Roth funds at such time as the participant was eligible for a distribution of that particular money type, or in other words had a distribution event .   For example, under SBJA a participant had to wait until age 59 ½ to convert his pre-tax deferrals to Roth assets.  ATRA now allows a participant to convert the pre-tax deferrals at any time, as long as the plan allows the conversion, even though there may not be an actual statutory distribution event for the money type.   

At first blush this new option seems an improvement over the old rules, which—due to their restrictiveness—did not generate much employer enthusiasm, or participant response.  Now, more participants may be able to more rapidly increase the volume of Roth-type assets in their accounts, which can be expected to yield more tax-free earnings.  What could be better than that?  Unfortunately, there are plenty of remaining uncertainties.  Until they are answered with IRS guidance, we would be surprised if a high percentage of plans adopt this option.  Here are just some of those questions.

Vested amounts only? Does the statute limit such conversions to vested amounts?  Industry interpretations differ but it appears based on the language of the statute that ANY amount can be converted, including non-vested amounts .  It is likely most would adopt a plan provision that would limit such ATRA-enabled conversions to vested amounts, as it is hard to imagine a participant being allowed to convert—and pay tax on—an amount, and subsequently have the risk of forfeiting it.  As this is something very new, guidance from the IRS as to how they view this is needed.

How to handle withholding?  The one unpleasant consequence of converting pre-tax assets to Roth assets is current taxation.  To avoid an under-withholding penalty, some taxpayers might prefer to convert less than the whole amount, and have some sent to the IRS as withholding to satisfy their anticipated tax obligation for the event.  This could readily be done with an in-plan Roth conversion under SBJA 2010’s rules, because only amounts eligible to be distributed could be converted.  Under ATRA, however, amounts NOT eligible for distribution CAN be converted.  Under ATRA’s rules, can an amount calculated to satisfy the tax obligation for the conversion be sent from the plan to the IRS as withholding, when the participant could not  take an actual distribution?   Our current interpretation is that it cannot be.  Based on this interpretation,  only participants who can satisfy the anticipated tax obligation by making an estimated tax payment from their non-plan resources may be in a position to take advantage of this option.  Or alternatively, individuals may be forced into numerous conversions, over different years to avoid excess income tax liability.   

Amendment guidance and timing?  Clearly understood is the general rule that plans must amend for a voluntary or discretionary change by the last day of the plan year in which the change occurs.  This would certainly apply to ATRA’s in-plan Roth conversion option, now available in 2013.  However, given the extent of unanswered questions, and the fact that IRS guidance is unavailable, flexibility to amend for a 2013 implementation by a more reasonable date is very important.  Without the expected IRS guidance in-hand when such an amendment is drafted there is a very real possibility that plans amending in 2013 could be required to amend a second time to shore up an amendment drafted prior to receiving IRS guidance.  We hope that the IRS will consider modifying the amendment deadline unless guidance is forthcoming very early in the year.

Disclosure of tax implications?  It is required that a notice of rollover options and tax consequences be provided to a plan participant or beneficiary when a distribution from a retirement plan is requested.  This is also true when an in-plan Roth conversion was requested under the provisions of SBJA 2010, because that conversion or rollover took place when the amount was distributable.  Under ATRA, a conversion may take place without a distributable event, so the detail provided in a typical distribution notice would appear not to apply.  However, given the tax consequences that could befall a plan participant or spouse beneficiary who executes an in-plan Roth conversion, one might expect that this information would have to be provided.  We hope the IRS will thoughtfully and adequately address this.

Motives and consequences?  The questions presented here are a sampling of some of important issues that should be addressed by the IRS, and soon.  Something beyond the IRS realm, however, is congressional motives.  The ATRA provisions permitting anytime conversion of pre-tax retirement plan assets were inserted into the legislation at the 11^th hour.  The purpose was to raise some $12.2 billion in tax revenues over the next 10 years, in order to offset the cost of other tax -related provisions in this “fiscal cliff” legislation.  This is the same strategy employed when Congress enacted the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which offered special 2-year taxation in 2011-2012 for 2010 Roth IRA conversions.  The objective then was to generate tax revenues in 2010, through Roth IRA conversions, in order to pay for other TIPRA tax provisions. 

While it can be argued that some taxpayers will be better off with more Roth assets and their potential for tax-free earnings, this is not necessarily true for everyone.  Furthermore, neither the 109^th Congress nor the present one appears to have been motivated by the principle of enhancing retirement security.  It is also ironic that, with so much focus on the national debt and on balancing federal revenues with expenditures, this Congress traded away greater future tax revenues for lesser immediate tax revenues in order to avert the fiscal cliff.  That is called “kicking the can down the road.”  Hopefully, the IRS will not do the same with the ATRA guidance that is so much needed.