In-Service Distribution of In-Plan Roth Conversions Prior to Age 59 1/2

I have a question about In-Plan Roth Conversions and the ability to take the conversions as In-Service Distributions prior to age 59 1/2.

Our plan document has a specific section for In-Service Distributions of In-Plan Roth Conversions. And, one of the Options is "any time", meaning that a participant can withdraw the In-Plan Roth Conversions at any time.

So, I have a hypothetical scenario. Employee A (who is, let's say 40 years of age) has been contributing Pre-Tax Deferrals to the plan. Normally, he would have to wait until age 59 1/2 to withdraw the deferrals as an in-service distribution. Instead, he chooses to do an in plan Roth Conversion (the plan document allows In-Plan Roth Conversions for all sources at any time). He then immediately (before there are any earnings) takes out an In-Service Distribution of these funds (because the plan document allows for In-Plan Roth Conversion amounts to be withdrawn in-service at any time). So, effectively, he avoided not only the 59 1/2 age restriction for in-service distributions, but also, the 10% penalty?

Is this scenario allowed under current regulations?

Thanks.

I don't believe that it is.

As I understand it from our document provider there are 2 types of In-Plan conversions of Pre-Tax money to Roth money.

The first is an In-Plan Rollover. This is available when the participant is eligible for a distribution under the Plan but choses to do an In-Plan rollover converting pre-tax to Roth. In this case the new funds are treated like a Related Rollover account in the Plan with Roth tax characteristics attached.

The second is an In-Plan Transfer to Roth. This is done when the Participant is not eligible for a distribution from the plan (unusally pre-59.5). In this case the the funds are converted to Roth, but the source retains all the other charateristics of the  source from which it was converted. So if it is 401(k) money subject to the pre-59.5 restriction on in-service distributions, that remains.

If I'm wrong I'd love to see a citation because otherwise it seems like a loophole to avoid some restrictions.

There are two ways a plan can allow in-plan Roth conversions:

1. Allow conversions only of amounts that are otherwise distributable to the employee. Once converted, the Roth conversion source may be distributed at any time, if allowed by the plan.

2. Allow conversions of vested amounts at any time, but retain the distribution restrictions associated with that money after the conversion. In this method, the plan would usually have to separately recordkeep each different Roth conversion source. For example, a plan that has deferrals, safe harbor match, and profit sharing, would also have to recordkeep deferral conversion, safe harbor match conversion, and profit sharing conversion sources.

The option to allow Roth conversions to be distributed at any time is only applicable when the plan uses the first method for Roth conversions.

Edit: Lou beat me to it by a minute. As he points out, some plans may use different terminology for the two methods, so read your document carefully. I do not think the methods have different names in the code or regs.

Agree with Lou and C.B. Zeller. The authority is Q&A-3 of Part B of Section III of Notice 2013-74:

Q-3. Is an amount rolled over to an employee’s designated Roth account pursuant to § 402A(c)(4)(E) subject to any distribution restrictions after the in-plan Roth rollover? A-3. Yes. If an amount is rolled over to a designated Roth account pursuant to § 402A(c)(4)(E), then, notwithstanding Revenue Ruling 2004-12, the amount rolled over and applicable earnings remain subject to the distribution restrictions that were applicable to the amount before the in-plan Roth rollover. Thus, for example, if a § 401(k) plan participant who has not had a severance from employment makes an in-plan Roth rollover of an amount from the participant’s pre-tax elective deferral account prior to age 59½, that amount and applicable earnings may not be distributed from the plan prior to attainment of age 59½ or the occurrence of another event described in § 401(k)(2)(B).

IRS Notices are not really authority, as would be regulations, but Q&A-3 does make sense.