Roth conversion opportunities

Beginning this year, a provision of the Pension Protection Act of 2006 allows participants to convert funds in 401(k)s and other company plans directly to a Roth IRA. Until now, plan participants had to roll funds over to a traditional IRA first and then convert that to a Roth. By eliminating the extra step, the new provision will make Roth conversions much easier and lessen the likelihood of transfer mistakes. While converting company plan funds directly to a Roth IRA still entails paying tax on the conversion, the amount of the tax sometimes can be reduced. For example, if the 401(k) contained after-tax funds, no tax would be due on the amount of the conversion that applied to the after-tax funds. This is a much improved state of affairs as compared with the earlier two-step conversion process, because all conversions from a traditional IRA that holds after-tax funds to a Roth IRA use the pro-rata rule, which says that distributions are partly taxable (see IRS Form 8606). When plan funds, including any after-tax amounts, were transferred to the IRA first, the pro-rata rule applied and more of the converted amount was subject to income tax. If there are after-tax funds in the employee plan (and little or no after-tax funds in a traditional IRA), then a conversion of plan funds directly to a Roth will generate less of a tax bite because only the pre-tax funds are taxable. This is because the after-tax amount becomes a smaller part of the total account balance when plan funds are combined with IRA funds. But don't think that you can roll plan funds to a separate IRA to avoid this result. The IRS is ahead of you there: All IRAs, including SEPs and SIMPLEs, are considered one for purposes of the pro-rata rule.

DIRECT TRANSFER

If funds are converted from a company plan, make sure the transfer is done as a direct (trustee-to-trustee) transfer in order to avoid having the 20% federal withholding tax taken from the distribution. This would leave only 80% of the funds to be converted and could cause a tax and a 10% penalty, if the client is under age 591/2, on the 20% withholding amount if the client does not have other funds to complete the conversion. The Roth conversion option is not an all-or-nothing choice. A client may want to convert some 401(k) funds directly to a Roth IRA and roll over the rest to a traditional IRA. Employers may or may not allow two trustee-to-trustee transfers — one to a Roth IRA and one to a traditional IRA. If not, ask if the company will write two checks. These should be made payable not to the employee, but to the custodian of the employee's Roth IRA and traditional IRA. The checks will qualify as trustee-to-trustee transfers, thereby avoiding the 20% withholding rules since the employee cannot cash the checks and take possession of the funds, which can go only to the IRAs. Of course, the employee still must qualify for the Roth conversion. For 2008 and 2009, a taxpayer with modified adjusted gross income (MAGI) above $100,000, or who is married but files a separate tax return, is not eligible to convert to a Roth IRA. In 2010, when additional tax changes go into effect, these restrictions disappear. Anyone with an IRA may convert it to a Roth IRA. Plan distribution rules have not changed, however, creating confusion over what the law allows and what company plans allow. Just because the law allows direct Roth IRA conversions doesn't mean employees can simply empty their 401(k) balances and convert those funds to Roth IRAs anytime they wish. The company plan still has final say and must permit the distribution. Some plans allow in-service distributions, which can be converted directly to a Roth IRA under the new law. If in-service distributions are not available, the employee must wait until the plan allows funds to be distributed, which is usually upon reaching retirement age or upon separation of service. The terms are described in plan documents. Ed Slott, a certified public accountant in Rockville Centre, N.Y., has created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.