Rules You Must Know to Convert a 401(k) to a Roth - IRS Notice 2008-30, Minimum Required Distributions on Inherited Roth IRAs & Restrictions for Beneficiaries

(July 1st, 2008)

The benefits of owning a Roth IRA over a 401k are huge. Tax-free growth of retirement funds, ability to take out qualified distributions, and no forced minimum required distributions (MRDs) are just some of the benefits. But did you know that you do not have to have a 401k to convert to a Roth? You could convert your employer's retirement plan (whatever it may be) to a Roth via a Roth IRA conversion. This feature is enabled by the Pension Protection Act of 2006, before which no other plan other than a 401k was allowed to be converted to a Roth IRA. In this article, we will explore how you can convert your corporate retirement plan to a Roth and what rules/provisions you must follow in order to successfully do this.

But before we do that, lets look at how this change was brought about. The Pension Protection Act of 2006 (PPA) amended the rules of how corporate retirement plans could be converted to Roth IRAs. Prior to the PPA of 2006, a Roth IRA could only accept rollover contributions from another Roth IRA (also known as qualified rollover contributions). This provision created a 2 step process for investors who wished to convert their corporate retirement plans to Roth IRAs. First, investors had to roll over their funds to a Traditional IRA and then make a qualified conversion to a Roth IRA. The Pension Protection Act of 2006 amended this rule by allowing other eligible retirement plans (such as corporate retirement plans) to be included in the definition of 'qualified rollover contributions.' This eliminated the need for investors to rollover their corporate retirement plans to a Traditional IRA, then make a conversion to a Roth IRA. Investors can now make a direct conversion from corporate retirement plans to a Roth IRA.

IRS Notice 2008-30

On March 5th, 2008, the IRS released Notice 2008-30 defining the provisions for converting corporate retirement plans into Roth IRAs. Here are the provisions.

i) Corporate retirement plans (401ks, 403bs or 457 plans) can now be converted directly to a Roth IRA.

ii) Modified Adjusted Gross Income (MAGI) cannot exceed $100,000 whether you are filing a joint or single tax return.

iii) You cannot be married but filing separate returns for the 2008 - 2009 tax year. This provision will be completely withdrawn starting 2010.

iv) Any amounts that are converted to a Roth IRA that would otherwise be taxable must be included in income in the year of the conversion

v) If the investor has after-tax contributions in his Non Roth account, the conversion to a Roth IRA will not be subject to the pro-rata rule. The pro-rata rule is when investors have to pay taxes on any pre-tax contributions (contributions that are made before taxes are deducted). Since tax has already been paid on the Non Roth contributions, any conversions or rollovers to a Roth IRA will not be subject to taxes.

vi) Direct rollovers from Non Roth accounts to a Roth IRA are NOT subject to a 20% withholding tax; however 60 day rollovers are.

Does it Make Sense to Rollover to a Roth IRA?

It makes sense to rollover your corporate 401k account to a Roth IRA if you plan not to take any distributions for many years, or not at all. This is an important point to remember because if you do rollover to a Roth IRA and take out a distribution, you will be hit with a 10% early withdrawal penalty as well as owe taxes if you're under 59 and 1/2 years of age or are within the first 5 years of your conversion.

Convert Inherited Retirement Plan Assets?

One important change the Pension Protection Act of 2006 brought about was that it now allows non-spouse participants (singles) who have inherited retirement plan assets from either a 401k, 403b or other retirement plans to convert to an inherited Roth IRA. This is unique and very confusing because beneficiaries cannot convert their inherited IRA assets into Roths, they can however convert other inherited retirement assets into a Roth. Here are a couple of important points to remember about this:

i) To convert retirement plan assets other than an IRA to a Roth, a non-spouse beneficiary must do a direct transfer of funds. A direct transfer means the funds are transferred directly from the administrator of your old retirement plan account to the manager of your Roth IRA, you do not get to enjoy the money in the process.

ii) If the non-spouse beneficiary receives a distribution in a 60 day rollover, he/she will NOT be able to roll those funds into a Roth IRA, Traditional IRA or an inherited IRA. What's worse, the beneficiary will owe taxes on the distributed amount.

iii) Be sure to verify that your corporate retirement plan allows non-spouse beneficiary rollovers to inherited Roth IRAs.

Minimum Required Distributions (MRDs) on Inherited Roth IRAs?

Once the non-spouse beneficiary does a direct transfer of funds to an Inherited Roth IRA, he/she will have to start taking minimum required distributions (MRDs) from the account. These distributions must begin the year after the death of person from whom the Roth was inherited. The amount of the distribution will be based on:

- The beneficiary's age
- Beneficiary's life expectancy

Restrictions for Beneficiaries

There are certain restrictions that beneficiaries have to face before they can convert a retirement asset into an inherited Roth IRA. Here are a few:

i) If the beneficiary converts from a corporate (employer-sponsored) plan to an inherited Roth IRA, he will have to pay the taxes up front and will not be able to defer taxes owed on the distributions over his lifetime. Thus the tax benefits of converting to an inherited Roth IRA are not huge.

ii) The beneficiary is subject to the same modified adjusted gross income (MAGI) rule as any other investor converting funds from a retirement account to a Roth IRA.