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. Then, in 2008, the IRS released specific rules about how the process should work. Here's how these conversions work and why you might want to consider making the switch.
The Pension Protection Act of 2006, commonly known as PPA, amended many rules relating to IRAs and qualified plans, including the rule that now allows retirement plan participants to roll over corporate retirement-plan funds directly into a Roth IRA. Before this amendment, 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 such as a Roth 401(k) or Roth 403(b).
This rule essentially created a two-step process for qualified plan participants who 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 new PPA amended the definition of qualified rollover contributions to include other eligible retirement plans, thus making the two-step process obsolete. It took a few years to clarify exactly how the new process should work. In March 2008, the IRS released rules spelling out the details for converting employer-plan funds directly into Roth IRAs, including the restrictions. In 2010, income limitations and rules banning married filing separately taxpayers from converting their 401(k)s to IRAs were removed.
The Conversion Process
These are the basic rules that apply to rolling over your corporate retirement plan into a Roth IRA:
- 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.
- Any funds converted into a Roth IRA that would otherwise be taxable must be included as income for the year of the conversion.
- If the plan participant has after-tax funds in their 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 mandatory 20% withholding, but 60-day rollovers are, so it is best to do a trustee-to-trustee transfer.
You can also roll over your retirement plan into some other assets – and roll many of them into a corporate plan. This summary from the IRS shows which conversions are permitted:
1. Qualified plans include, for example, profit-sharing, 401(k), money purchase, and defined benefit plans.
2. Only one rollover in any 12-month period
3. Must include in income
4. Must have separate accounts
5. Must be an in-plan rollover
6. Any nontaxable amounts distributed must be rolled over by direct trustee-to-trustee transfer.
7. Applies to rollover contributions after December 18, 2015
When Do Conversions to a Roth IRA 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 IRA within five years of the conversion, and
- You are younger than 59½ 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 401(k).
First-time homebuyers may take out up to $10,000 to help finance the purchase of the home, if you have held the Roth IRA for five years, without penalty. Likewise, funds can be withdrawn without penalties, if the money is used to pay for education, like college tuition or room and board.
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.
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), they 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 roll over the funds into a Roth IRA, 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.
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 required minimum distributions (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.
Restrictions for Beneficiaries
Now that AGI and marital restrictions no longer apply to the beneficiary, the main concern is that if the beneficiary does the conversion from an employer plan, they will have to pay the taxes up front. Any change before the Dec. 31 conversion deadline will be treated as ordinary income.
The Bottom Line
While these rules on Roth conversions from corporate retirement plans are great for some, they won't benefit everyone. What the PPA 2006 did was 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 you're interested in starting an IRA account, check out Investopedia's list of the best brokers for Roth IRA.