Taxation Rules on In-Plan Roth Conversions

Tip of the Day

By Stephanie Reagan

sreagan@sunlin.biz

This article provides information on the Federal 10% early distribution penalty tax, 10% recapture tax and income tax regarding after-tax and pre-tax contributions and account earnings on in-plan Roth conversion transfers.

Federal 10% Early Distribution Penalty Tax and 10% Recapture Tax

  • First of all, you don't have to worry about the 10% penalty if you are age 59½ or older.

  • After-tax employee contributions in a plan are not subject to the 10% early distribution penalty tax and can be distributed from the plan at any time. After-tax contributions’ plan earnings that are distributed would generally be subject to the 10% early distribution penalty tax if the participant is under age 59 ½ (or doesn’t qualify under another exception under IRC Sec. 72(t)(2)).

  • Transferring After-tax contributions, pre-tax contributions and account earnings to an in-plan Roth conversion account would not cause the 10% early distribution penalty tax on conversion if the converted amounts are kept in the plan.
  • If a participant’s Roth in-plan conversion assets are withdrawn within five years of an in-plan Roth conversion, the participant would owe the 10% recapture penalty tax on the portion of the withdrawal attributable to the taxable amount of the conversion (recapture penalty) in addition to distributed earnings accumulated in the in-plan Roth account (10% Early Distribution Penalty Tax) unless the participant is age 59½ or more or qualifies under another exception under IRC Sec. 72(t)(2). (Notice 2010-84 Q&A 12)

  • For determining the taxable amount in the recapture tax calculation,
    • An in-plan Roth conversion of After-tax Employee contributions transfer would be the earnings taxed at the time of the transfer not the whole basis transfer amount.
    • For any pre-tax conversion amounts transferred to an in-plan Roth conversion account, the recapture tax would apply to the whole basis amount distributed because the whole amount was taxed at the time of the transfer .
  • Each in-plan Roth conversion has a separate five-year holding period for determining whether a withdrawal of converted money (basis) is subject to a 10% recapture penalty tax. If a participant has multiple in-plan Roth conversions, distributions of the Roth account’s basis would be on a first-in first-out basis.

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Income Tax on In-Plan Roth Conversion Transfers

Only one five-year holding period, the earlier of when one first contributes to the plan’s Roth account or when the in-plan Roth conversion happens, is used for the purposes of determining whether Roth earnings may be withdrawn income tax-free and the distribution is made after a person reaches age 59½ (or is disabled or dead).

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Quoting the IRS Q&A on the taxation of In-Plan Conversions

“How are in-plan Roth rollovers taxed?

You generally include the taxable amount (fair market value minus your basis in the distribution) of an in-plan Roth rollover in your gross income for the tax year in which you receive it.

Plan sponsors shouldn’t withhold taxes from direct rollovers to designated Roth accounts, but employees who make in-plan Roth rollovers may need to increase their withholding or make estimated tax payments to avoid an underpayment penalty.

In-plan Roth rollovers are not subject to the 10% additional tax on early distributions. However, they are subject to a special recapture rule when a plan distributes any part of an in-plan Roth rollover within a 5-taxable-year period, making the distribution subject to the 10% additional tax on early distributions under IRC Section 72(t) unless:

•             an exception to this tax applies, or

•             the distribution is allocable to any nontaxable portion of the in-plan Roth rollover.

The 5-taxable-year period begins January 1 of the year of the in-plan Roth rollover and ends on December 31 of the fifth year. This special recapture rule does not apply when you roll over the distribution to another designated Roth account or to your Roth IRA, but does apply to a subsequent distribution from the rolled over account or IRA within the 5-taxable-year period.”

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On a final note, converting pre-tax dollars in the plan to an in-plan Roth account is a great way of getting more $ in the plan (whose earnings could be tax free on distribution) because since one could pay the tax on the conversion with personal assets, the participant in effect has just managed to make a large Roth contribution to the plan without being subject to testing and the dollar limits of Sections 402(g) and 415.

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