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 11th 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 109th 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.
