The New In-Plan Roth Conversions

Transcription

1 The New In-Plan Roth Conversions ABA Section of Taxation Midyear 2011 Meeting January 20-22, 2011 Moderator: Kathryn J. Kennedy, The John Marshall Law School Panelists: - William Bortz, Associate Benefits Tax Counsel - Susan Diehl, PenServ Plan Services, Inc. - Mark Iwry, Senior Adviser to the Secretary and Deputy Assistant Secretary for Retirement and Health Policy - Andrew Zuckerman, Director, EP Rulings and Agreements (TEGE) PenServ Plan Services, IRS Circular 230 Disclosure This information is provided for educational and informational purposes and is not intended to be used to avoid tax penalties or to render tax or legal advice. The taxpayer should seek advice from an independent tax and/or legal advisor. PenServ Plan Services,

2 Historical Information Roth IRAs created in Designated Roth Contributions created in 2006 for 401(k) and 403(b) plans. Prior to 2008, conversions to Roth IRAs could only be made from Traditional IRAs, SEPs, and SIMPLEs. Beginning in 2008, conversions to Roth IRAs permitted from QPs, 403(b)s, governmental 457(b)s. PenServ Plan Services, Historical Information For 2008 and 2009, conversion eligibility rules still applied: Less than $100,000 AGI Married taxpayers required to file jointly In 2010, conversion eligibility rules eliminated. SBJA of 2010 permits in-plan Roth rollovers for eligible rollover distributions made after September 27, PenServ Plan Services,

3 Historical Information Roth accounts are funded with after-tax dollars. Qualified distributions are tax-free; penalty-free. To be a qualified distribution, must be made after 5-year aging period and be due to 59½, death or disability. Employee has one 5-year period under each employer s plan for determining whether or not a distribution from that plan is a qualified distribution. Does not carry over to a Roth IRA. PenServ Plan Services, Historical Information If a distribution is made from a designated Roth account that is not a qualified distribution, the taxable amount of the distribution is calculated using the pro-rata basis recovery calculation under 72. Designated Roth accounts are NOT subject to the ordering rules applicable to a Roth IRA where the Roth IRA owner takes basis first! PenServ Plan Services,

4 Which Plans may contain an In- Plan Roth Rollover (IRR)? Effective for eligible rollover distributions made after September 27, 2010 from: A 401(k) A 403(b) Effective for eligible rollover distributions made after December 31, 2010 from: A Governmental 457(b) Note These plans will be permitted for the first time to contain a Designated Roth Account in PenServ Plan Services, IRS Guidance IRS Notice issued November 26, 2010 contains guidance for 401(k) and 403(b) plans relating to IRRs. Retirement News for Employers (Fall 2010) Article. Forms/Pubs Division issued reporting guidance on IRS website. Draft form 8606 posted IRS website. PenServ Plan Services,

5 What is an IRR? An IRR is an eligible rollover distribution from an individual s account under a 401(k), 403(b) or in 2011 from a governmental 457(b), (other than from a Designated Roth Account) to a Designated Roth Account in the same Employer s plan. PenServ Plan Services, How can an IRR be accomplished? An IRR can be accomplished by: A direct rollover (in-plan Roth Direct Rollover) [no withholding]; 60 day Rollover by the Participant (In-Plan Roth 60 day Rollover) [withholding applies] PenServ Plan Services,

6 Who can elect an IRR? An IRR can be elected by: A plan participant; A surviving spouse beneficiary; or An alternate payee spouse or former spouse under a QDRO. PenServ Plan Services, Who cannot elect an IRR? A non-spouse beneficiary is not eligible to make an IRR. However, a non-spouse beneficiary may elect a direct rollover to an inherited IRA, including a direct rollover conversion to an inherited Roth IRA in accordance with 402(c)(11). PenServ Plan Services,

7 What amounts are eligible for IRRs? Participant must have a distributable event under the terms of the plan. Amounts must otherwise be an eligible rollover distribution (e.g., RMD not eligible for an IRR). Vested amounts only. All available monies except Designated Roth Account. PenServ Plan Services, What amounts are eligible for IRRs? If participant is still working, IRRs from pre-tax elective deferrals may not be made until the participant: Attains age 59 ½; Dies; Becomes Disabled; or Receives a Qualified Reservist Distribution. Only if plan permits. PenServ Plan Services,

8 What amounts are eligible for IRRs? Pre-tax elective deferral accounts also include: Safe harbor matching Safe harbor nonelective Qualified nonelective (QNECs)** Qualified matching ** IMPORTANT NOTE: Corrective contributions in non- ERISA 403(b)s are considered QNECs. (e.g., Employer contributions for failing Universal Availability are QNECs even in a K-12 Plan.) PenServ Plan Services, IRRs not considered a distribution for certain rules IRRs are not considered a distribution for the following purposes: Loans that are direct rolled over in an IRR are not considered a new loan; Spousal consent rules under 401(a)(11) not required; 411(a)(11) Notice for cash-outs of greater than $5,000 not triggered; Protected Benefit rules apply. PenServ Plan Services,

9 Adding new, permissible distribution options A plan can add new, permissible distribution options to allow IRRs, but that restrict the monies to stay within the plan. However, a plan cannot be amended to restrict a distribution to only being made as an IRR if the plan already permitted a distribution. Such amendment would violate the protected benefit rules of 411(d)(6). PenServ Plan Services, Participant Disclosure Information 402(f) Rollover Notice must be updated. ERISA Plans must update their Summary Plan Descriptions, or provide Summary of Material Modifications (SMMs). Distribution forms must be updated for the participant to elect an IRR. PenServ Plan Services,

10 Can an IRR be undone? No. Unlike a conversion to a Roth IRA that can be recharacterized to a traditional IRA, an IRR cannot be undone. If a participant elects an IRR, that decision cannot be changed. PenServ Plan Services, What are the tax consequences of an IRR? The taxable amount included in income is the same amount that would be included had the distribution been converted directly to a Roth IRA. Taxable amount reduced by any after-tax contributions or loan repayments after default. IRRs that include outstanding loans are taxed when converted. 20% mandatory withholding does not apply to direct IRRs. PenServ Plan Services,

11 When is an IRR taxable? IRRs are taxed the year of distribution. IRRs made in 2010 are subject to the 2-year income spread (over 2011 and 2012), unless the taxpayer elects to include in 2010 income. Election made on Form 8606 and is irrevocable after the 2010 tax filing deadline including extensions of the taxpayer. There is no recharacterization option for IRRs! PenServ Plan Services, Year Income Spread All IRRs must be treated the same (2-year spread or 2010 income inclusion). All conversions to Roth IRAs must be treated the same (2-year spread or 2010 income inclusion). The election that applies to 2010 IRRs are independent from the election that applies to conversions to Roth IRAs. PenServ Plan Services,

12 Income Acceleration Rule If the 2-year spread is used, the income acceleration rule would apply for distributions allocable to the IRR taken before entire amount has been included in income. PenServ Plan Services, Income Acceleration Rule Example #1: Jean makes a taxable IRR in 2010 of $8,000 and is using 2-year spread. With no distributions, $4,000 is taxed in 2011; $4,000 in In 2010, Jean takes out $5,000 that is allocable to the IRR. Jean s 2010 income is increased by $5,000. The remaining $3,000 is taxed in Nothing is taxed in 2012 under this example. PenServ Plan Services,

13 Income Acceleration Rule Example #2: Same facts, except that Jean takes a distribution of $3,000 during 2011 from her IRR. Nothing is taxed in $7,000 taxed in 2011 ($4,000 scheduled + $3,000 distribution in 2011) $1,000 taxed in 2012 (remaining amount of the original $8,000 IRR) PenServ Plan Services, Consequences of Death or Divorce Death or divorce before end of 2-years: Death the remaining amount is accelerated and reported on the final tax return of the decedent. If the sole beneficiary is the spouse, spouse may continue the 2-year spread, unless accelerated due to a distribution. Divorce If participant is married in 2010 and then subsequently divorces before the end of the 2-year period, the participant continues the 2-year spread, unless accelerated due to a distribution. PenServ Plan Services,

14 10% Recapture Tax Rule 10% Recapture Tax Rule An IRR is not subject to the 10% premature distribution tax. 10% is recaptured if any distribution is made allocable to each IRR before 5 years. The 5 year period begins on January 1 st of the year of each IRR and ends on December 31 st of the 5 th year. Recapture tax does not apply if the taxpayer meets another exception under 72(t) age 59 ½, death, disability, separation from service after age 55, certain medical expenses, qualified reservist distribution, etc. PenServ Plan Services, % Recapture Tax Rule Example Carol makes a $20,000 taxable IRR during year period begins on 1/1/2011 and ends on 12/31/2015. On 4/30/2015 at age 40, she takes out $6,000 allocable to the taxable IRR that was made in She meets no exception to the 10% premature penalty tax. She owes a tax of $600 ($6,000 X 10%) on her 2015 tax return. Had she waited until 2016, the 5-year recapture tax on her 2011 IRR would not have applied. PenServ Plan Services,

15 10% Recapture Tax Rule The 10% recapture rule does not apply to any distribution that is properly rolled over to another eligible plan. The 5-year recapture period carries over to the receiving plan, and would apply to a subsequent distribution before the original 5- year period expires. This 5-year clock is not reset if rolled over. PenServ Plan Services, % Recapture Tax Rule The 5 year recapture period for the 10% premature tax applies to each IRR and is totally separate from the 5-year aging rule which is used for determining whether the distribution is a qualified distribution. See example on the next slide. PenServ Plan Services,

16 Two 5-Year Rules!! Example: Rocky makes an IRR on 2/16/2011. He also made his first Roth elective deferral on 10/1/2010. The 5-year aging period for determining qualified distributions began on 1/1/2010. The 5-year period for determining the 10% recapture tax began on 1/1/2011 for just the 2011 IRR. PenServ Plan Services, How is the taxable portion of a distribution from the IRR calculated? Solely for purposes of the income acceleration rule and the 10% recapture tax rule: A distribution from IRR must constitute a prorata basis recovery by first looking at total designated Roth account balance and entire earnings. A distribution from a Roth deferral account treated as attributable to IRR if basis portion exceeds deferral basis. IRR distributions: first-in-first-out basis. PenServ Plan Services,

17 IRR Distribution Example In 2010 Pete, age 45, makes a $100,000 direct IRR with $90,000 taxable; $10,000 nontaxable. With 2-year spread: $45,000 taxed in 2011; $45,000 taxed in No 10% premature tax applies due to the IRR. No withholding applies since a direct IRR. IRR is separately accounted. Plan issues a 2010 Form 1099-R: $100,000 in box 1; $90,000 in box 2a; $10,000 in box 5; Code G in box 7. Pete files a 2010 Form 8606 with his tax return. PenServ Plan Services, IRR Distribution Example Pete also has a Roth deferral account. On 12/20/2010, Pete requests a distribution of maximum amount possible. Only source available is balance in IRR, because he is only age 45 and still working. At the time of the requested distribution, Pete s total designated Roth account is comprised of the following: PenServ Plan Services,

18 IRR Distribution Example IRR Account IRR contributions $100,000 ($10,000 of which was nontaxable) Earnings on IRR account $ 6,000 Total IRR balance $106,000 Roth Deferral Account Roth deferrals to date $ 80,000 Earnings on deferral account $ 24,000 Total Roth Deferral Account $104,000 Total designated Roth balance $210,000 PenServ Plan Services, IRR Distribution Example Amount available for distribution $106,000 Total earnings in designated Roth $ 30,000 Total designated Roth balance $210,000 Apply pro-rata calculation for taxable and return of basis amounts: $106,000 X $30,000/$210,000 = $15,143 taxable $106,000 - $15,143 = $90,857 return of IRR basis PenServ Plan Services,

19 IRR Distribution Example Amount subject to 10% premature tax: $90,000 original taxable amount of IRR; plus $15,143 taxable amount of IRR distribution $105,143 subject to 10% premature tax $ 10,514 amount of 10% premature tax (Pete may need to file form 5329 with his tax return). $0 remains for the 2-year spread R issued: $106,000 in box 1; $15,143 in box 2a; $90,857 in box 5; Code B in box 7. Pete must file Form 8606 showing original IRR, the IRR distribution, the income acceleration, and the 10% recapture tax. PenServ Plan Services, IRR Distribution Example After the $106,000 distribution, Pete still has $9,143 allocated to his IRR account because the entire $90,857 return of basis is allocated solely to his IRR account. His participant separate accounting immediately after the $106,000 IRR distribution looks like this: PenServ Plan Services,

20 IRR Distribution Example IRR Account IRR remaining basis $ 9,143 Earnings on IRR $ 0 IRR account balance $ 9,143 Roth Deferral Account Roth deferrals $ 80,000 Earnings $ 14,857 Roth deferral balance $ 94,857 Total designated Roth balance $104,000 PenServ Plan Services, IRR Distribution Example Note: If Pete takes the remaining $9,143 allocable to his IRR account, none will be taxable or subject to the 10% penalty because the entire taxable amount of the original IRR was used up in the $106,000 distribution. PenServ Plan Services,

21 Amendment Deadlines Traditional 401(k)s - later of: the last day of the year in which amendment is effective; or 12/31/2011. Safe Harbor 401(k)s later of: 12/31/2011; or before the first day of the plan year in which the safe harbor provisions are effective. 403(b)s later of: the end of the employer s remedial amendment period; or the last day of the first plan year when the amendment effective. PenServ Plan Services, Extended Amendment Deadline Extended Amendment Deadline applies to the following amendments: To permit IRRs; To permit Roth Elective Deferrals; To permit rollovers into the Designated Roth Account; and To add new, permissible distribution options. This does not permit an extension of time to add a 401(k) feature to an existing profit sharing plan. PenServ Plan Services,

22 Designated Roth Program must be in place In order for participants who make a 2010 IRR to use the 2-year income spread, a designated Roth program must be operationally in place. Although an extended amendment deadline applies, this means that participants must be given the opportunity to elect to defer into the plan as a post-tax Roth deferral. Updated salary reduction agreements may be necessary. PenServ Plan Services, Recordkeeping Because of distribution restrictions, taxation of distributions, income acceleration rule and the 5-year 10% recapture rule, the following types of money within a designated Roth account should be separately accounted for: Roth elective deferrals Incoming rollovers from a designated Roth account under another employer s plan In-plan Roth rollovers (IRRs) PenServ Plan Services,

23 How is an IRR reported on Form 1099-R? Issued concurrently with Notice , the IRS Retirement News for Employers provided that the Form 1099-R is completed as follows for a 2010 IRR: Box 1: Box 2a: Box 2b: Box 5: Box 7: Gross amount of the IRR Taxable amount of the IRR Don t check tax amount not determined Basis amount (after-tax) Code G PenServ Plan Services, How does the employee report an IRR on Form 8606? Draft version of 2010 Form 8606 provides: Employee must file Form 8606 with 2010 tax return. IRRs reported in Part III, Form Distributions from IRRs reported on certain lines in Part IV, Form Traditional IRA conversions to Roth IRAs reported in Part II, Form Conversions to Roth IRAs from employer plan, a separate Form 8606, Part III required. PenServ Plan Services,

24 Reporting a 2010 distribution from an IRR Report as any other distribution from a designated Roth account. Box 1: Gross Box 2a: Taxable Box 4: Withholding Box 5: Basis recovered Box 7: Code B or B1 1 st Year of Designated Roth Contribution Blank box to left of Box 10, amount allocated to IRR PenServ Plan Services, How do conversions to a Roth IRA compare to IRRs? Advantages of converting to Roth IRA: No RMDs while living. Recharacterization option. Ordering rules (basis first; no pro-rata). Distributions available at any time. Roth IRAs have only one 5-year aging period, regardless of the number of Roth IRAs. Different exceptions to the 10% premature distribution, including 1 st time homebuyers for a qualified distribution. PenServ Plan Services,

25 How do conversions to a Roth IRA compare to IRRs? Advantages of in-plan conversions: Plan loans. ERISA protection from creditors. Investment choices and lower expenses possibly. Keep retirement assets in one plan. NUA possible on employer securities. PenServ Plan Services, Why will waiting until 2013 seriously impact taxation? Patient Protection and Affordable Care Act, as modified by the Health Care and Education Reconciliation Act of 2010 were enacted on 3/23/2010. Impacts penalty-free distributions. Adds new 3.8% Medicare tax on unearned income for certain taxpayers increased AGI due to a conversion could make this new tax apply. PenServ Plan Services,

26 PPACA (Health Care Reform) Effective in 2013 Itemized medical expense deduction threshold increased to 10% of AGI (up from 7.5% AGI) Affects penalty-free distributions from retirement accounts for deductible medical expenses of the taxpayer. PenServ Plan Services, PPACA (Health Care Reform) Effective in 2013 A 3.8% Medicare tax on unearned income applies to higher income taxpayers (AGI greater than $200,000 for individuals or $250,000 for joint filers) Unearned income includes interest, dividends, capital gains, annuities, royalties, rents, etc. Taxpayer will be responsible for paying this tax (not an employer through withholding). Will impact conversions that increase AGI!! PenServ Plan Services,

27 PPACA (Health Care Reform) Example: Individual Filer in 2013 Wages $ 75,000 Unearned Income $ 50,000 Conversion $100,000 Total AGI $225, % Medicare Tax on $50,000 of interest income because AGI > $200,000 Conversion becomes part of AGI that makes interest income subject to 3.8% Medicare tax PenServ Plan Services, Questions? PenServ Plan Services,