(From the July 16, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

$100,000 Adjusted Gross Income Restriction Applies to Roth 401(k) to Roth IRA Rollovers in 2008 and 2009

Employers that have implemented Roth 401(k) plans -- or are planning to do so in the near future -- should be aware of an apparent glitch in the Internal Revenue Code that will prevent participants with adjusted gross incomes of more than $100,000 from rolling their Roth 401(k) balances into a Roth IRA during 2008 and 2009. Ironically, this temporary obstacle to Roth 401(k) to Roth IRA rollovers is the result of Congress' efforts to eliminate barriers to transferring all types of money (in particular, funds held in accounts other than designated Roth contribution accounts) from tax-qualified retirement plans to Roth IRAs. Congress could fix the problem with legislation, or let it go away on its own in 2010. Either way, until it is corrected employers with Roth 401(k) plans will need to tell higher income participants they may have to wait until 2010 to transfer their balances to a Roth IRA.

Background

Congress created the Roth IRA as part of the Taxpayer Relief Act of 1997 (P.L. 105-34). Unlike traditional IRAs, there is no way to deduct contributions to Roth IRAs. However, distributions from Roth IRAs are tax free if certain requirements are satisfied. Single taxpayers with adjusted gross incomes (AGIs) of more than $110,000, and joint taxpayers with AGIs of more than $160,000, are not eligible to contribute to Roth IRAs.

The popularity of the tax treatment afforded Roth IRAs prompted Congress to make a similar option available to 401(k) plan participants as part of the Economic Growth and Tax Relief Reconciliation Act ("EGTRRA") of 2001 (P.L. 107-19). Since 2006 the law has permitted 401(k) plans to add a "designated Roth feature," to which participants can make "designated Roth contributions." These designated Roth contributions are made with after-tax dollars, but subsequent distributions of these amounts -- and any earnings thereon -- are not taxed if certain requirements are satisfied. Significantly, in contrast to Roth IRAs, there is no AGI-based limit on eligibility to contribute to Roth 401(k)s.

Rollovers and Conversions

It is possible to convert a traditional IRA to a Roth IRA, but the amount transferred from the traditional IRA to the Roth IRA generally is subject to tax in the year of the conversion. Currently, IRC § 408A(c)(3)(B) prevents taxpayers with AGIs of more than $100,000 from converting their traditional IRAs to Roth IRAs. However, the Tax Increase Prevention and Reconciliation Act ("TIPRA") of 2005 (P.L. 109-222) repealed IRC § 408A(c)(3)(B) effective for taxable years beginning after December 31, 2009. Thus, in 2010 and beyond there will be no AGI limit on converting traditional IRAs to Roth IRAs. Furthermore, the tax consequences of conversions occurring in 2010 will be spread evenly over a two-year period, beginning in 2011.

There is no way to convert pre-tax elective deferrals to a 401(k) plan to designated Roth contributions. (The election to make designated Roth contributions applies prospectively only.) However, designated Roth contributions can be rolled into another Roth 401(k) or Roth IRA, and these rollovers currently are not subject to the $100,000 AGI limit applicable to rollovers or conversions of traditional IRAs to Roth IRAs.

The law originally did not provide a mechanism for direct rollovers of any amounts held under a qualified plan, including pre-tax 401(k) elective deferrals. Only the Roth account in the 401(k) plan could be directly rolled over to a Roth IRA. However, a rollover of non-Roth funds in a qualified plan to a Roth IRA can be accomplished indirectly by rolling pre-tax elective deferrals into a traditional IRA and then converting the traditional IRA to a Roth IRA. But this two-step process is inefficient and, until the repeal of IRC § 408A(c)(3)(B) takes effect in 2010, the second step of this process is not available to taxpayers with AGIs exceeding $100,000.

The PPA amended IRC § 408A(e) to permit direct rollovers from "eligible retirement plans" -- including 401(k) plans with or without "designated Roth features," other tax-qualified retirement plans, 403(b) plans, and governmental 457 plans -- to Roth IRAs, effective for distributions after December 31, 2007. This change was primarily intended to eliminate the need to use the two-step process to transfer pre-tax elective deferrals and accounts other than designated Roth accounts from a 401(k) plan to a Roth IRA.

Here's the Problem ...

The PPA also amended IRC § 408A(c)(3)(B) to impose the $100,000 AGI restriction on rollovers to a Roth IRA from any "eligible retirement plan" other than another Roth IRA. The term "eligible retirement plan" is defined by IRC § 402(c)(8) and specifically encompasses tax-qualified plans (including 401(k) plans with designated Roth features), 403(b) plans, and governmental 457 plans. As a result, during the 2008 and 2009 taxable years IRC § 408A(c)(3)(B) will prevent anyone with AGI of more than $100,000 from rolling funds from any source -- including a Roth 401(k) -- into a Roth IRA.

There is nothing in the legislative history of the PPA to suggest Congress intended to restrict anyone's ability to roll money from a Roth 401(k) to a Roth IRA. Nonetheless, that is the effect of IRC § 408A(c)(3)(B) as amended by the PPA. Thus, unless Congress changes the law (again), the $100,000 AGI limit will apply to rollovers from Roth 401(k)s to Roth IRAs in 2008 and 2009. Of course, the solution for employees who find themselves in this situation is to leave the money in the Roth 401(k) until 2010.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.