If your client wants to convert employer plan funds directly to a Roth IRA, there are some new Internal Revenue Service (IRS) rules you should be aware of. The Pension Protection Act of 2006 (PPA) allows such conversions beginning in 2008. In some cases, after-tax plan funds can be converted to a Roth IRA tax-free, if only those funds are converted and the remaining plan funds are rolled to a traditional IRA. Notice 2008-30 confirms that Roth conversions can be done from employer plans such as 401(k)s, 403(b)s and 457s.
Before Jan. 1, 2008, a taxpayer could only convert IRA funds to a Roth IRA. Employer plan funds first had to be moved to an IRA and then they could be converted to a Roth. The PPA did away with this two-step process this year.
The Roth conversion eligibility rules still apply. In order to convert, a taxpayer's modified adjusted gross income (MAGI) cannot exceed $100,000, and he or she must be filing a joint or a single return (not married filing separate). These rules will be permanently repealed as of Jan. 1, 2010, but for 2008 and 2009 anyone converting funds to a Roth IRA must meet them.
Surprise!
Notice 2008-30 contains a completely unexpected provision allowing a non-spouse plan beneficiary also to convert an inherited plan balance to an inherited Roth IRA. In effect, the new rules create two classes of non-spouse beneficiaries, since IRA beneficiaries cannot convert their inherited IRAs to Roth IRAs, but plan beneficiaries can.
How can beneficiaries convert inherited plan funds to an inherited Roth IRA when they cannot convert inherited IRA funds to a Roth? The answer lies in changes made to the tax code when PPA was passed. A Roth conversion is reported as a rollover, and a non-spouse beneficiary cannot do a rollover. That is why a non-spouse beneficiary cannot do a Roth conversion of an inherited IRA. But the PPA changed the law to allow a non-spouse beneficiary to do a direct rollover of an inherited employer plan, and this is what makes it possible for a non-spouse beneficiary to do a conversion of inherited plan assets.
To be eligible for the Roth conversion, non-spouse beneficiaries must also meet the same MAGI and filing status requirements as plan participants. To work, the transfer from the plan must be a direct transfer. A beneficiary who receives a distribution of inherited plan assets that is payable to the beneficiary (a 60-day rollover) will not be able to roll those assets over to any inherited IRA—traditional or Roth. The beneficiary will owe taxes on the distribution and will have lost the stretch opportunity.
Understanding RMD
Roth IRA owners are not subject to required minimum distributions (RMDs), but non-spouse Roth IRA beneficiaries are. After converting the inherited plan assets to an inherited Roth IRA, the beneficiary must take RMDs from the inherited Roth. This could make doing a Roth conversion of inherited assets less attractive, unless the beneficiary is young. A 20-year-old beneficiary has a 63-year life expectancy, so little has to be withdrawn each year, leaving a greater balance to grow tax-free for a longer period of time.
Advisors now have new items to check for non-spouse beneficiaries who inherit company plan funds. Taking into consideration that the non-spouse beneficiary has to take RMDs from an inherited Roth IRA, should he or she pay the tax to convert an inherited employer plan asset to an inherited Roth IRA?
The answer depends on whether your clients can pass some initial hurdles. Only beneficiaries who can answer yes to the following questions can reap the benefits of this provision:
- Does the employer plan allow a non-spouse beneficiary to do a direct rollover to an inherited IRA?
- Do the beneficiaries meet the qualifications for doing a Roth conversion? Income must not exceed $100,000, and they cannot file married-separate (for 2008 and 2009).
- Can the beneficiary pay the income tax with other funds?
Since a trust is also a non-spouse beneficiary, a trust that is the plan beneficiary can also take advantage of the new rules. There are, however, several unanswered questions about the mechanics of how trusts would qualify.
Until 2010, income and marital restrictions must be met in order to do a Roth conversion. How will those limits apply to a trust? Does the trust have to meet the $100,000 MAGI, or must the income of the trust beneficiary meet that test? If the trust has multiple beneficiaries, which beneficiary is used for the income test? A trust does not fit into the marital status categories. Would the marital rule be disregarded, or would it be applied to trust beneficiaries?
If a beneficiary has the option of converting his or her own IRA or inherited employer plan assets to a Roth IRA, converting the IRA would make more sense. There would be no RMDs during the beneficiary's lifetime, and at his or her death a spouse could inherit the Roth, roll it over to the spouse's own Roth and continue deferring RMDs. The owned Roth IRA would have many years to grow and compound on a tax-free basis before non-spouse beneficiaries would be required to take RMDs.
If limited funds are available and the beneficiary has personal IRAs, the funds are probably best used to convert the beneficiary's own IRA funds to his or her own Roth IRA first. Look at life insurance as a source of tax-free post-death cash to pay the beneficiary's conversion tax. The beneficiary might also have inherited other non-IRA funds that could be used to pay the conversion tax.
IRD Issues
Most beneficiaries and planners are unaware of the income in respect of a decedent (IRD) deduction that is available to beneficiaries. This deduction can keep tens or hundreds of thousands of dollars in the beneficiary's pocket.
The deduction was put in place to help mitigate the effect of double taxation on individual income that is not subject to income tax before the individual's death. At the death of the individual, this income is subject to both income tax and estate tax. Retirement plans are one of the biggest items subject to this double taxation.
A non-spouse beneficiary of an employer plan included in an estate that pays federal estate taxes is eligible for the IRD deduction. The deduction will offset some of the taxes due on a Roth conversion and could make a Roth conversion a more financially viable option for the beneficiary.
The Future
The PPA was an attempt to level the inherited retirement asset playing field. While IRA beneficiaries could stretch distributions over their life expectancies, employer plan beneficiaries had more limited options. Most were forced to take immediate, taxable payouts or withdraw the funds over a maximum of five years, losing the stretch opportunity.
With the implementation of this PPA provision, the pendulum has swung the other way. Now, the non-spouse employer plan beneficiary has an option that is not available to the non-spouse IRA beneficiary. Congress must recognize this inequity and take steps to fix the problem. In the future we may see non-spouse IRA beneficiaries able to do conversions to inherited Roth IRAs, just like plan beneficiaries can now do.
Ed Slott, a CPA in Rockville Centre, N.Y., is an IRA distribution expert, professional speaker and author of several IRA books. For more, visit www.irahelp.com.
