The benefits of owning a Roth IRA are quite clear; among them are the tax-free growth of assets and the ability to stretch distributions over one's lifetime. But did you know that you may qualify for a Roth conversion directly from your corporate retirement plan? Previously prohibited, the Pension Protection Act of 2006 initiated provisions that enable plan participants to convert employer-plan balances to Roth IRAs. However, specific guidelines had not been revealed by the
How the Change Came About
The Pension Protection Act of 2006, commonly known as
i) Company retirement plan assets, including those from 401(k), 403(b) and 457(b) governmental plans, can now be converted directly to a Roth IRA.
ii) The normal Roth conversion rules still apply, including:
iv) If the plan participant has after-tax funds in his qualified plan account, the conversion of plan assets to a Roth IRA will NOT be subject to the pro-rata rule, which states that participants have to pay personal income taxes on any deductible pretax contributions. It does not apply to after-tax funds converted to a Roth IRA because the participant has already paid taxes on those contributions.
v) Direct rollovers of plan funds into a Roth IRA will not be subject to a 20% withholding, but 60-day rollovers are, so it is best to do a trustee-to-trustee transfer. (For more insight, read Did Your Roth IRA Conversion Pass Or Fail?, The Simple Tax Math Of Roth Conversions and Recharacterizing Your IRA Contribution Or Roth Conversion.)
When Do Conversions Make Sense?
The right candidates for retirement plan rollovers into Roth IRAs are usually individuals who will not need to take distributions from the account for many years or who won't take any distributions at all. This is important to remember if you convert the retirement plan funds into a Roth IRA, because you will have to pay a 10% penalty on the funds withdrawn if the following applies:
- You withdraw funds from the Roth IRAwithin five years of the conversion, and
- You are younger than 59.5 and don't qualify for an exception to the 10% penalty.
Impact on Non-Spouse Beneficiaries
One of the most significant changes the
But before you attempt to rollover the funds into a Roth IRA, you should make sure that the employer plan allows non-spouse beneficiary rollovers into an inherited IRA. A lot of plans do not, but if yours does, then you should be able to roll over the funds into a Roth IRA. (Check out Inherited Retirement Plan Assets - Part 1 and Part 2 for further reading.)
Beneficiaries are Subject to Required Minimum Distributions (RMDs)
Once the beneficiary successfully rolls over the retirement-plan assets directly into an inherited Roth IRA, that person will have to start taking RMDs from the inherited Roth IRA. These distributions must begin the year after the death of the person from whom the account was inherited, and the amounts will be based on the beneficiary's age. These minimum distributions are not taxable (because the tax has already been paid in the conversion), they are not assessed with penalties (regardless of age) and they are based on the beneficiary's life expectancy.
This is important to understand, especially if the beneficiary of the account is older. It may not make sense to convert the account and have to take large distributions, even if these are tax free. There simply may not be enough time to make up for what you lost in taxes on the conversion. (Head over to our article Avoiding RMD Pitfalls to learn more.)
Restrictions for Beneficiaries
There are several restrictions and obstacles that beneficiaries have to overcome to be able to roll over a retirement plan into an inherited Roth IRA. Here are some of the major ones:
- The beneficiary is subject to the same AGI and marital restrictions as any other owner converting IRA funds into a Roth, but only for 2008-2009.
- If the beneficiary does the conversion from the employer plan, he or she will have to pay the taxes up front.
While these rules on Roth conversions from corporate retirement plans are great for some, they won't benefit everyone. What the
For further reading, be sure to check out our Roth IRAs Tutorial.