An in-plan Roth rollover (IPRR) is effective for distributions from Internal Revenue Code Section 401(k) plans and IRC Section 403(b) plans made after Sept. 27, 2010 and for distributions from IRC Section 457(b) plans for taxable years beginning after 2010.¹ But a taxpayer needs to consider certain factors before deciding whether an IPRR makes sense. Here are the rules on IPRRs and the key points to consider in determining whether an IPRR is the most attractive option for your client.

IPRR Fundamentals

Here are the basics:

What is it? An IPRR is an eligible rollover distribution from an individual's plan account, other than a designated “Roth account,” that's rolled over to the individual's Roth account in the same plan, pursuant to IRC Section 402A(c)(4).

Who can make an IPRR? A plan participant, a surviving spouse beneficiary or an alternate payee who's a spouse or former spouse of the plan participant may make an IPRR. Nonspouse beneficiaries aren't eligible to make an IPRR.² A plan must have a qualified Roth contribution program in place when a rollover contribution to a Roth account is made.³ A plan isn't required to offer IPRRs.

What plans? An IPRR can be made in Sections 401(k), 403(b) and 457(b)⁴ plans that have adopted qualified Roth contribution programs if the plan so allows. The plan distribution rules apply, including the required minimum distribution (RMD) rules. RMD rules don't apply to Roth individual retirement accounts during the owner's lifetime.

What does it cost? The recipient must include the fair market value (FMV) of the IPRR reduced by any basis in gross income. For payments from a plan in 2010 that were rolled over to a Roth account in the plan (and that aren't distributed from that account until after 2011), the rollover is taxed one-half in 2011 and one-half in 2012, unless the recipient elects to be taxed on the entire amount in 2010. This result is the same if the rollover were made to a Roth IRA.

An IPRR is a revenue raiser.⁵ The Joint Committee on Taxation Report for the Small Business Jobs Act of 2010 estimated the budget effects of allowing IPRRs at $5.099 billion for the period from 2011 through 2220. The budget effect of expanding IPRRs to Section 457 plans effective for taxable years beginning after Dec. 31, 2010 is $560 million for the same period.

How? An IPRR may be made by a direct rollover (an “in-plan Roth direct rollover”) or by a distribution of funds to the distributee who then rolls over the funds into his Roth account in the same plan within 60 days (an “in-plan Roth 60-day rollover”). An IPRR that's a direct rollover isn't subject to the 20 percent mandatory withholding under IRC Section 3405(c). But, an IPRR that's a 60-day rollover is subject to the 20 percent mandatory withholding. Unless the distributee rolls over the entire 100 percent by contributing from his own pocket the 20 percent withheld, the 20 percent withheld is subject to a possible 10 percent additional early withdrawal tax!

Can you change your mind? No. An IPRR can't be recharacterized and treated as if the rollover hadn't been made. Consequently, if the market dives after the IPRR, income tax is still owed on the entire amount (less basis) of the IPRR. This could mean paying income taxes on losses. A rollover to a Roth IRA can be timely recharacterized to avoid paying income taxes on losses. (For more information, see “How to Murder a 2010 Roth IRA Conversion” by Michael J. Jones, p. 51.) A rollover to a Roth IRA is more advantageous than an IPRR on this issue.

Eligible Rollover Distributions

Practitioners had hoped that any account in a plan could be subject to an IPRR in the same plan at any time by any participant or any beneficiary. For example, practitioners hoped that a participant could roll over a pre-tax account or any employer account to a Roth account at any time. Not so.

The only amounts eligible for an IPRR are vested amounts that are eligible rollover distributions under the IRC and under the plan. Under the IRC, to have an eligible rollover distribution from a pre-tax account in a plan, a plan participant must have had a severance from employment, reached age 59½, died, become disabled or received a qualified reservist distribution.⁶ After-tax contributions and rollover contributions are usually not subject to such limitations on distributions. These limitations also don't apply to certain in-service distributions of employer contributions if the plan so provides. For example, some plans provide that a participant may withdraw certain employer contributions after reaching a certain age,⁷ after participating in the plan at least five years⁸ or after the employer contribution has been in the plan for at least two years.⁹

A plan can be amended to liberalize the distribution options permitted by the IRC. Q&A-4 of Notice 2010-84 provides:¹⁰

Q-4. Can a plan add an in-plan Roth direct rollover option for amounts that are not otherwise distributable under the terms of the plan but that would be permitted to be distributed under the Code if the plan so provided?

A-4. Yes. A plan may be amended to add an in-plan Roth direct rollover option for amounts that are permitted to be distributed under the Code but that have not been distributable under more restrictive terms contained in the plan. Moreover, such an amendment is not required to permit any other rollover or distribution option for these amounts. For example, a plan that does not currently allow for in-service distributions from a participant's pre-tax elective deferral account may be amended to permit in-plan Roth direct rollovers from this account by participants who have attained age 59-1/2, while not otherwise permitting distribution of these amounts. (However, a plan amendment imposing such a restriction on a pre-existing distribution option would violate Code §411(d)(6).)

This is an interesting provision but adds to recordkeeping if the amendment applies only for IPRR purposes and not for other distributions! It's doubtful that many plans will find this attractive.

As noted above, only an eligible rollover distribution can be the subject of an IPRR. A distribution from a plan isn't necessarily an eligible one. For example, an eligible rollover distribution doesn't include:¹¹

• distributions that are RMDs, that is, distributions made in the “first distribution year”¹² and thereafter;
• distributions that are one of a series of substantially equal periodic payments made over a term certain of 10 years or more or over life, life expectancy or joint lives or joint life expectancies;¹³
• distributions that are refunds of elective deferrals;¹⁴
• distributions that are corrective distributions of excess deferrals, contributions and income thereon;¹⁵
• defaulted loans that are treated as distributions;¹⁶
• dividends paid on employer securities pursuant to an employee stock ownership plan;¹⁷
• the PS 58 cost of life insurance coverage;¹⁸
• hardship distributions from a qualified plan;¹⁹
• a distribution from an eligible automatic contribution arrangement under IRC Section 414(w); and
• cash distributions of less than $200 per year.

Why Rollover?

Why would a taxpayer want to make an IPRR to a Roth account? What's special about a Roth account? The special Roth account rules allow a plan participant or beneficiary to withdraw earnings from a Roth account tax-free if the distribution is qualified.²⁰ If the distribution isn't qualified, earnings are subject to ordinary income tax and a 10 percent additional income tax for early withdrawal unless an exception applies. Any withdrawal will be a combination of contributions and earnings. This is a different rule from the rule that applies to distributions from Roth IRAs.

Amounts withdrawn from a Roth IRA (but not from a Roth account) are treated as made in the following order: (1) from regular contributions that aren't subject to income tax; (2) from conversion contributions that may be subject to income tax on a first-in, first-out basis with distributions allocated to a qualified rollover or conversion contribution treated as coming first from the portion, if any, that was includible in gross income as a result of the conversion; and (3) from earnings that may be subject to income tax.²¹ This means that distributions from Roth IRAs are deemed made first from amounts contributed that aren't subject to income tax and then from earnings, except in the case of certain rollovers or conversions. Consequently, nonqualified distributions from a Roth IRA aren't taxable if only contributions are withdrawn. However, distributions from a Roth account are always taxable if the account has any earnings, because any withdrawal is a combination of contributions and earnings. A rollover to a Roth IRA is more advantageous than an IPRR on this issue.

Two Requirements

There are two requirements for a “qualified distribution” from a Roth account. The distribution must be made:

1. After the five-taxable-year period. Contributions to a Roth account must be held for five taxable years before any earnings can be withdrawn tax-free (five-taxable-year period). The five-taxable-year period begins on the first day of the tax year for which the plan participant first makes a contribution to his Roth account and ends when five consecutive tax years have been completed. For example, if a calendar year taxpayer first made Roth contributions to a Roth account on July 1, 2008, the five-taxable-year period would end Dec. 31, 2012. This holds true even if the IPRR occurs after Sept. 27, 2010 in the case of Section 401(k) plans and Section 403(b) plans or after taxable years beginning after 2010 in the case of Section 457(b) plans. If a plan participant participates in more than one plan offering Roth accounts, there will be more than one five-taxable-year period, determined by the date on which the plan participant first made contributions to a Roth account under each plan.²² There's only one five-taxable-year period for a Roth IRA. The Roth IRA rules are more liberal than the Roth account rules on this issue.

2. For the correct reason. To be a qualified distribution, the distribution must also be made for one of the following reasons: to the plan participant after he reaches age 59½; to his beneficiary because the plan participant has died; or to the plan participant after he's disabled.

Note that these rules are the same as the rules that apply to Roth IRAs, except that a distribution for a qualified first-time home purchase isn't allowed. All withdrawals from a Roth account that aren't qualified distributions are subject to income tax on earnings as determined on a pro rata basis unless an exception applies. Withdrawals from a Roth IRA aren't taxed on a pro rata basis. As noted above, the rules are more liberal for Roth IRAs than for Roth accounts.

Ten Percent Additional Income Tax

What is the 10 percent additional income tax? If an IPRR is made and a later distribution from that account isn't a qualified distribution, the five-taxable-year period begins with the taxable year in which the IPRR was made for purposes of determining whether the 10 percent additional income tax under IRC Section 72(t) applies.²³ If the IPRR occurred sometime in 2011, the five-taxable-year period would begin Jan. 1, 2011 and wouldn't end until Dec. 31, 2015 for purposes of the 10 percent additional income tax. The 10 percent additional income tax would apply only if part or all of the original IPRR was subject to income tax, the subsequent distribution isn't a qualified distribution and no exception under Section 72(t) applies. There are exceptions to the 10 percent additional income tax. The exceptions are found in Section 72(t). Similar rules apply to distributions from a Roth IRA if those distributions aren't qualified distributions.

When an IPRR Will be Appealing

An IPRR is easy to accomplish because the plan participant, surviving spouse or alternate payee (who's a spouse or former spouse) need only file forms with the plan administrator. It's not necessary to deal with the sponsor of a Roth IRA. Also, an IPRR will appeal to a taxpayer if:

1. Taxpayer's tax bracket doesn't get much lower. The taxpayer will be in as high a tax bracket (or slightly lower tax bracket) at the time of distribution from the Roth account as the taxpayer was when the IPRR was made.

2. Taxpayer pays little income tax. The taxpayer has a charitable deduction carry forward or other tax credits that can be used to offset the tax due or the taxpayer anticipates a large increase in the value of the retirement plan account. An IPRR before the growth will cost less.

3. Separate funds can be used to pay income taxes. The taxpayer has separate funds from which to pay the income taxes due because of the IPRR. There's more opportunity for growth within the Roth account if taxes are paid outside the plan.

4. Taxpayer plans to withdraw only qualified distributions or intends to roll over the Roth account to a Roth IRA. If not, funds withdrawn within five years of the IPRR may be subject to the additional 10 percent income tax if the distribution is taxable under Section 72(t).

5. Taxpayer is still young. The taxpayer is young and has many years until retirement.

6. Taxpayer has a short life expectancy and wants the Roth account to fund an exclusion trust or wants to pass the Roth account to children at taxpayer's death. The exclusion trust or gift to children could be funded with the Roth account after death. Distributions from the Roth account wouldn't be income in respect of a decedent as long as they were qualified distributions and, consequently, would be more valuable to the beneficiaries than taxable distributions. The federal and state income tax incurred prior to death and payable because of the IPRR could be deductible for estate tax purposes. If there are no estate taxes, this alternative may not be attractive since it involves paying income taxes early.

7. Diversification desired. The taxpayer wants to diversify retirement funds over various retirement vehicles — that is, Roth accounts in a 401(k) or similar plan, traditional IRAs, Roth IRAs, annuities and so forth. The taxpayer wants to diversify tax exposure. Distributions from Roth accounts can escape income tax if the distribution is qualified.

8. Social Security payments aren't affected. After an IPRR, withdrawals from Roth accounts aren't taxable if the withdrawals are qualified distributions and, hence, wouldn't affect the taxability of Social Security payments. The taxpayer's adjusted gross income (AGI) will be lower and Social Security may escape taxation and Medicare B premiums may be lower.

When an IPRR Will be Unappealing

An IPRR won't appeal to a taxpayer if:

1. The taxpayer finds that an IPRR is too expensive.

2. Withdrawals are needed. The taxpayer needs to withdraw funds for living expenses, college tuition for dependents or other reasons that aren't qualified distributions. Such a taxpayer gains no benefit from paying income taxes early on an IPRR.

3. The taxpayer is in a much lower tax bracket when the funds are withdrawn from the Roth account than when they were contributed. The taxpayer may gain little, if any, benefit from paying the taxes early on an IPRR if the taxpayer uses the account for retirement.

4. The taxpayer is on Social Security. Income from an IPRR is AGI for purposes of determining whether Social Security benefits are taxable and for purposes of determining Medicare premiums. Additional income in the year of the IPRR could cause a retiree's Social Security benefits to be taxed and could cause higher Medicare premiums.

5. The taxpayer prefers a Roth IRA. The taxpayer wants the flexibility of recharacterization if the market dives in the year of the rollover and he doesn't want to withdraw RMDs from the IPRR account at retirement. RMDs alone can reduce the account 4 percent to 5 percent when the taxpayer is age 71 through 80, 5 percent to 8 percent when the taxpayer is age 81 through 90 and 9 percent to 52 percent when the taxpayer is age 91 or older. RMDs don't apply to Roth IRAs so the IRA can grow and the taxpayer can control cash flow and withdrawals. If a taxpayer makes an IPRR and then decides that he doesn't want to take RMDs, the taxpayer should arrange a transfer from his Roth accounts to a Roth IRA prior to the year in which he reaches age 70½ to avoid RMDs.

IPRR vs. Roth IRA Rollover?

Why an IPRR rather than a rollover to a Roth IRA? An IPRR may not be the best choice. Remember that an IPRR can't be recharacterized and is subject to RMDs, while a Roth IRA can be timely recharacterized and isn't subject to RMDs. Nevertheless, an IPRR may be more attractive than a rollover to a Roth IRA because the participant may prefer the investments offered by the retirement plan. Perhaps the employer pays some of the investment costs. Perhaps the participant doesn't want to “bother” with creating a Roth IRA. Perhaps the plan won't allow an in-service rollover to a Roth IRA.

There are drawbacks to an IPRR if employer securities are involved. The net unrealized appreciation (NUA) exclusion for employer securities attributable to employee contributions isn't available on an IPRR.²⁴ The NUA exclusion applies to employer securities that are distributed from a qualified plan.²⁵ The term “employer securities” includes securities of a parent or subsidiary corporation.

For example, assume an employee has purchased company stock with a very low basis in his 401(k) plan. He retires and takes a lump sum distribution. He rolls over his distribution to an IRA except for the company stock. He retains the company stock in his own name. He's taxed on the basis in the employer stock as ordinary income. He's not taxed on the NUA, that is, the market value minus the cost or other basis. He's taxed on the NUA only upon a later sale and then at long-term capital gains rates.²⁶ This result isn't available in an IPRR. In an IPRR, the FMV for purposes of income tax on the rollover includes any NUA.

Does an IPRR make sense for the plan participant? Maybe. An IPRR can be valuable since income taxes on earnings can be avoided and not just deferred upon distribution. The same is true for a Roth IRA. Tax-free qualified distributions are the key to both IPRRs and rollovers to Roth IRAs. Both IPRRs and rollovers to Roth IRAs make sense if the taxpayer takes only qualified distributions and if the taxpayer's tax bracket (or that of the beneficiary) is as high (or slightly lower) at the time of distribution as it was at the time of the IPRR, that is, the taxpayer (or beneficiary) recovers the cost of the IPRR or rollover and more funds are realized. A Roth account or Roth IRA can be a wonderful retirement fund for the retiree or inheritance for a child or grandchild. As long as the Roth account or Roth IRA has been in existence for five years, there will be tax-free growth and tax-free distributions to the retiree or beneficiaries.

The bottom line? Rollovers to Roth IRAs are more attractive than IPRRs. The taxpayer has more favorable rules for the calculation of the five years that the account must be in existence, more favorable rules for the recharacterization of the rollover and more favorable rules for the taxation of the distributions from the Roth IRA after the rollover. But, if the plan doesn't allow an in-service rollover to Roth IRAs but will allow an in-service IPRR, an IPRR may be the only option available. In that case, IPRRs make sense if the taxpayer can afford the initial cost and wants tax-free growth and tax-free qualified distributions.

Endnotes

1. An In-plan Roth Rollover (IPRR) was added by Section 2112 of the Small Business Jobs Act of 2010, Pub. L. No. 111 240.
2. But they can make a trustee-to-transfer to an inherited Roth individual retirement account. Internal Revenue Service Notice 2008-30; 2008-12, Internal Revenue Bulletin 638.
3. Notice 2010-84, IRB 2010-51, IRB 872 (Nov. 29, 2010) Q&As 14, 19 and 20.
4. Ibid, Section II.
5. Committee Report for JCX-48-10, P.L. 111-240 (Sept. 16, 2010).
6. Internal Revenue Code Section 401(k)(2)(B)(i); IRC Section 72(t)(2)(G)(iii); Notice 2010-84, supra note 3, Q&A 2.
7. A plan may define normal retirement age at any age. Revenue Ruling 80-276, 1980-2 C.B. 131.
8. Rev. Rul. 68-24, 1968-1 C.B. 150.
9. Rev. Rul. 71-295, 1971-2 C.B. 184.
10. Notice 2010-84, supra note 3.
11. Treasury Regulations Section 1.402(c)-2 Q&A 4.
12. IRC Section 402(c)(4)(B).
13. IRC Section 402(c)(4)(A).
14. Supra note 11.
15. Ibid.
16. Ibid.
17. Ibid.
18. Ibid.
19. IRC Section 402(c)(4).
20. IRC Section 402A.
21. IRC Section 408A(d)(4)(B); Treas. Regs. Sections 1.408A-6, -8.
22. Treas. Regs. Section 1.402A-1, Q&A-4(b).
23. Treas. Regs. Section 1.408A-6, Q&A-5(c).
24. Notice 2010-84, supra note 3, Q&A-7.
25. Treas. Regs. Section 1.402(a)-1(b)(2)(i).
26. See IRC Section 402(e)(4) and Treas. Regs. Section 1.402(a)-1(b)(1)(i).

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Marcia Chadwick Holt is of counsel to the law firm of David Graham & Stubbs LLP in Denver

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