By Steven M. Etkind and Roger D. Lorence (Sadis & Goldberg LLP) – Employers offering 401(k) or 403(b) plans should give immediate attention to legislation that was just enacted that allows participants to convert their retirement accounts in such plans to Roth accounts in 2010 and avoid unnessary complications in order to convert Roth eligible accounts to Roth IRA’s.

The Small Business Jobs Act of 2010 (the “Act”), which became law on September 27, 2010, enacted an immediately effective important tax break for individuals who want to convert retirement plan accounts in a 401(k) plan into a Roth account. Participants in a Section 403(b) plan (whose sponsor is either a Section 501(c)(3) charity or a public school) can also benefit from the change in law, but participants in a plan that does not offer a Roth option, such as a plan that is solely a profit sharing plan, would not benefit from the amendment.

Contributions to traditional IRAs are made from pre-tax compensation and are generally deductible (in some cases nondeductible contributions can also be made). Contributions to Roth IRAs are made from after-tax dollars but if certain requirements are met, distributions are not taxable to the recipient. Under prior law retirement plan sponsors were faced with technical obstacles that could make it difficult to provide its participants who were still in-service with the sponsor with the option of converting regular 401(k) accounts into a Roth account while retaining those amounts within the plan’s accounts.

Under the Act’s amendment, a plan can, but is not required to, permit Roth conversions of account monies within the plan, provided that the plan has a provision allowing Roth IRA elective deferrals. The amendment would allow participants to retain their retirement monies within the plan while at the same time having the opportunity to receive tax-free qualifying Roth distributions in the future.

Prior to this change in the law, plan participants who wanted to do a Roth conversion had to roll their money out of the 401(k) plan into a separate IRA, and make the election separately. The 401(k) plans had to allow others as well to roll money out of the 401(k) and into separate IRAs.

Conversions in 2010 Can Be Especially Beneficial

Plan participants who want to convert in 2010 will benefit from a special election that permits the participant to defer recognition of the income triggered by the 2010 conversion to 2011 and 2012. Moreover, the amounts converted are not subject to the 10% penalty that would otherwise apply if the amounts were not rolled over into an IRA.

Action Plan

Some plans will have to be amended if the sponsors want to take advantage of the Act’s liberalization of the conversion rules. Plan sponsors that want to amend their plans to take advantage of the Act’s conversion feature and the 2010 deferral rules as well will need to get started very promptly on implementing the required changes to their documents. Plan sponsors contemplating making these changes will need to consult their plan advisors at the earliest opportunity.

If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (setkind@sglawyers.com) or Roger D. Lorence, 212-573-8413 (rlorence@sglawyers.com). We welcome your input.