Compliance Article
10/23/2007
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“Can I roll my employer plan assets to a Roth IRA?” is a question we’ve heard countless times. Unfortunately the answer has always been, “No, but you may roll employer plan assets to a traditional IRA, and then convert the traditional IRA to a Roth IRA.” In the end, the assets arrived at the intended destination, but in between there was extra time and paperwork. The wait will soon be over. Thanks to the Pension Protection Act (PPA) of 2006, assets of certain eligible retirement plans (ERPs), including plans under Internal Revenue Code (IRC) Sections 401(a), 403(a) and (b), and 457(b), will be eligible for rollover to a Roth IRA. This provision is effective January 1, 2008. Note: This article does not address rollovers of designated Roth account assets from 401(k) or 403(b) plans.
Who’s Eligible?
The current traditional IRA to Roth IRA conversion eligibility rules apply to ERP-to-Roth IRA rollovers. For example, the modified adjusted gross income (MAGI), whether filing singly or jointly, may not exceed $100,000. Also, a married individual may not convert unless he/she files a joint federal income tax return. Compensation or earned income is not required, nor are there any age restrictions. Note that the $100,000 MAGI limit and the joint filing requirement for married individuals will no longer apply for conversions occurring after December 31, 2009.
Just like ERP to traditional IRA rollovers, plan participants who meet their plan’s requirements, spouse beneficiaries of deceased plan participants, and spouses awarded some or all of a plan participant’s assets in an ERP through a divorce settlement, may all take advantage of the new law.
It’s Taxable
It’s worth noting that moving pretax assets to a Roth IRA is a taxable transaction. Some transaction flexibility is possible, however, allowing an individual to roll any combination of pretax and after-tax assets to a traditional IRA, a Roth IRA, or a combination of the two. For instance, an individual may still roll pretax assets to a traditional IRA and after-tax assets (if any) to a Roth IRA, preserving the associated tax benefits of the assets. As with traditional IRA-to-Roth IRA conversions, a discussion with a tax professional before rolling employer plan assets to a Roth IRA is a good idea.
Good News for Financial Organizations
So why go through the extra work of opening a traditional IRA when the participant wants the ERP assets in a Roth IRA? The answer is simple—currently, it’s the law.
The good news is, starting January 1, 2008, no one will have to spend time opening a traditional IRA as a step in the process of moving ERP assets to a Roth IRA. The new law makes sense, and may make certain financial organization employees’ jobs a little easier.
Good News for IRA Owners As Well
Currently an IRA owner who rolls ERP assets to a traditional IRA must file IRS Form 8606, Nondeductible IRAs, with his/her tax return if the rollover includes after-tax assets. This establishes basis in the IRA. If the owner does not report this to the Internal Revenue Service (IRS), he/she could end up paying taxes twice on the same assets. An IRA owner must file Form 8606 every year he takes a distribution from an IRA if he has basis in an IRA, even if the actual nondeductible assets are in another IRA. The IRS treats all of an owner’s traditional IRA assets as one IRA.
The requirement to track basis is a headache many people would like to avoid and this is exactly where the new law benefits the IRA owner. When the new law goes into effect, an eligible plan participant may roll over any after-tax assets directly to a Roth IRA. This will eliminate the requirement of tracking after-tax assets (basis) in a traditional IRA and provides the Roth IRA owner with the possibility of generating tax-free earnings.
Example
Under the current rule: Phil, age 55, retires from his job as an IRA consultant. He wants to move his 401(k) assets ($90,000 pretax, and $10,000 after-tax) to a Roth IRA. Phil’s keen knowledge of the IRC, specifically Section 402(c)(8)(B), makes him aware that he must first roll his 401(k) assets to a traditional IRA. Phil opens a traditional IRA at ABC Bank, completes a Request for Direct Rollover to a Traditional IRA, and the ERP directly rolls the entire amount to his traditional IRA. ABC Bank has Phil complete an IRA Rollover Review form to verify that the assets are eligible for rollover.
Phil then opens a Roth IRA and converts $100,000 in his traditional IRA to a Roth IRA. ABC Bank has Phil complete a Roth IRA Rollover or Conversion Review form, verifying his eligibility to convert his traditional IRA assets to a Roth IRA. Phil’s MAGI is less than $100,000, and he will file a joint federal income tax return.
Phil also has $100,000 of pretax assets in another traditional IRA at XYZ Credit Union. Phil must file Form 8606 to report the rollover of after-tax assets to his traditional IRA, and also to report the basis on his $100,000 conversion to the Roth IRA. $95,000 of Phil’s conversion is taxable—$5,000 is tax free. The $10,000 of after-tax assets in Phil’s IRA represents five percent of his total traditional IRA assets ($200,000), thus only $5,000 of the $100,000 conversion amount is nontaxable.
Under the new rule: Phil postpones his retirement and rollover plans until he reaches age 56 in 2008. He is now able to take advantage of the new rules and roll his 401(k) assets directly to a Roth IRA requesting the rollover using a Request for Direct Rollover to a Roth IRA. Phil can roll over the entire $10,000 after-tax balance tax free, and he does not have to worry about basis calculations on future traditional IRA distributions. Furthermore, since Phil decided to roll just the after-tax assets from his 401(k) to his Roth IRA, and roll the $90,000 of pretax assets to his traditional IRA, Phil reduces his reporting burden and maintains the tax deferral of his pretax assets.
Transaction Method
An eligible recipient can either elect a direct rollover, thereby authorizing his/her plan administrator to send the assets directly to an IRA custodian/trustee for the benefit of his/her IRA, or he/she could take a distribution and subsequently roll it over within 60 calendar days. Required minimum distributions are not eligible for rollover, either to a traditional IRA or a Roth IRA.
Is Recharacterization Possible?
What happens if an individual rolls his/her retirement plan assets to a Roth IRA and then determines that he/she is not eligible or cannot afford (or doesn’t want to pay) the tax bill? What remedy is available? Is there a penalty? Can he/she recharacterize the assets back to the ERP, or to a traditional IRA? To date, the IRS has not addressed these issues. Future guidance is expected.
Reporting Requirements Still Unknown
At this time we do not know how IRA custodians/trustees should report the receipt of ERP assets to Roth IRA. It could be a rollover, as defined in the IRC. It could be a conversion. On the other hand, the IRS could choose to call it something new and update the associated forms accordingly. We do expect to see changes to the following 2008 IRS forms and instructions: Form 8606 and its instructions; Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.; and Form 5498, IRA Contribution Information, and their instructions. The timing of this guidance is unknown. Readers can find current IRS forms and instructions on this site. Click these links or click on Get Informed, Research Library, and IRA/CESA.
