Must-Know Rules For Converting A 401(k) To A Roth

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 IRS, and so the process garnered very little attention from investors. Let's shed some light on how these conversions work, and why you might want to consider making the switch.

How the Change Came About

The Pension Protection Act of 2006, commonly known as PPA, amended many rules relating to IRAs and qualified plans, including the rule that allows retirement plan participants to roll over corporate retirement-plan funds directly into a Roth IRA. Prior to the amendment by the PPA, a Roth IRA could only accept rollover contributions distributed from another Roth IRA (referred to as "60-day rollover contributions"), a non-Roth IRA referred to as a conversion, or a rollover from another designated Roth account also known as a Roth 401(k) or Roth 403(b). This rule essentially created a two-step process for qualified plan participants that wished to convert the funds into a Roth IRA and stretch out the distributions over their lifetimes. First, participants had to roll the funds over into a Traditional IRA, and then convert these assets into a Roth IRA. Section 824 of the PPA amended the definition of qualified rollover contributions to include other eligible retirement plans, thus making the two-step process obsolete. (If you want to learn more on the PPA, check out Pension Protection Act Of 2006 Becomes Law.)

IRS Notices And Clarifications
On March 5, 2008, the IRS released Notice 2008-30, spelling out the details for converting employer-plan funds directly into Roth IRAs, including the restrictions. Here's the simplified version of the rule:

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:

iii) Any funds converted into a Roth IRA that would otherwise be taxable must be included as income for the year of the conversion.

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.

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.

Another important consideration in making your decision to convert the funds is having the ability to pay the taxes up front for the conversion from a source other than the Roth IRA. (Read Avoiding IRS Penalties On Your IRA Assets to learn which transactions can have expensive consequences.)

Impact on Non-Spouse Beneficiaries
One of the most significant changes the PPA made is that non-spouse participants now have the ability to roll over the inherited retirement-plan assets into inherited Roth IRAs, which they were previously unable to do. This is significant because beneficiaries cannot convert inherited IRA funds into Roth IRAs, but they can now convert inherited retirement-plan assets into an inherited Roth IRA - go figure. However, in order for the non-spouse beneficiary to take advantage of the Roth IRA, they must do a direct transfer. If the beneficiary receives the distribution (a 60-day rollover), he or she will not be able to roll those assets into any inherited IRA, Traditional IRA or Roth. Not only that, but the beneficiary will owe taxes on the distribution and will miss out on the ability to stretch out the account. Again, this is why it is so critical for the plan participant or beneficiary to request a direct rollover or trustee-to-trustee transfer.

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 PPA 2006 has done is to provide more options to both retirement-plan participants and the beneficiaries of these plans. You don't have to roll over the assets into a Roth IRA, but you still have the option to roll over your retirement plan into a traditional IRA or traditional inherited IRA if you are the beneficiary, which is frequently the best option. IRAs not only provide you with more investment options, but also with greater flexibility for estate planning. If the reason for not taking advantage of the Roth IRA happens to be the MAGI limits, and the corporate retirement plan is a good one, you may even consider leaving the assets behind until 2010, when the MAGI limits are repealed.

For further reading, be sure to check out our Roth IRAs Tutorial.