Editor’s Note: Last Friday, we inadvertently omitted substantive information from Frank Palmieri’s article on Roth IRA rollovers. As a result, we are running a revised version of the article.

Much has been written about the ability for individuals to roll over from a 401(k) plan to a Roth IRA, starting this year. Married couples filing jointly and single taxpayers earning under $100,000 in modified adjusted gross income per year were able to participate in Roth IRA rollovers in 2009.

However, what is new for this year is individuals earning over $100,000 can benefit from the individual financial planning this allows, regardless of their filing status. Individuals may elect to receive a distribution of traditional pretax 401(k) salary deferral, matching and employer contributions, and to roll over funds to a Roth IRA.

After receiving the distribution, an individual pays current taxes on the distribution amount. Then, the amounts rolled over grow tax-free without being subject to future income taxes. Individuals deciding whether or not to effectuate a Roth rollover must consider numerous issues, including their level of taxation in 2010 and their anticipated level of taxation in retirement.

The primary advantages of a Roth IRA distribution include:

• No future individual income taxes are paid on distributions from a Roth IRA, and funds grow tax-free.

• Unlike traditional IRAs and 401(k)s, money in a Roth IRA is not subject to the required minimum distribution rules that start at age 70 1/2. Thus, if an employee retires at age 68, the funds can keep growing tax-free in a Roth IRA even after the retiree reaches age 70 1/2.

• Significant amounts may be transferred to spouses and children without being subject to income taxes, depending upon estate and state tax issues.

Issues to consider

The primary disadvantage for a Roth IRA rollover is whether or not an employee guesses correctly. Popular planning ideas on this issue include:

• An employee may pay taxes in 2010 on the full amount of the Roth IRA rollover. Most practitioners believe that the lowest effective tax rate will be available for highly compensated employees in 2010. Most highly compensated individuals will pay alternative minimum taxes at a 28% tax rate in 2010.

• Individuals can choose to have the amount received in 2010 taxed over two years in 2010 and 2011, and not be required to file a tax return until April 15, 2011 for the 2010 tax year. Thus, an individual can decide whether or not they wish to spread the income taxes over two calendar years, with hindsight to determine whether tax rates have increased significantly as of Jan. 1, 2011.

• The 10% excise tax on early withdrawals does not apply to direct Roth IRA rollovers. Other articles and computer models have reviewed the math associated with the Roth IRA rollover election. However, these frequently overlook whether an employer's qualified retirement plan actually permits a distribution. To accomplish a Roth IRA rollover, a distribution event must exist, such as an employee leaving an employer or turning age 59 1/2.

HR professionals may begin receiving questions from highly compensated employees early this year about the procedures to complete a Roth IRA rollover. At that time, HR professionals will review their qualified retirement plans to determine if a distribution is permitted.

Most plans will not allow a distribution for a 45-year-old senior executive who has worked for the company for five years. HR departments will contact the recordkeepers and legal counsel for their plans. At that time, they must consider whether their retirement plans are maintained on standardized or nonstandarized prototype plans, volume submitter plans and/or individually designed plan documents.

Planning opportunity

Some employers may be told that a Roth IRA rollover is not permitted under the terms of their plan. While this may be true in many situations, a significant planning opportunity exists. Under IRS Revenue Ruling 68-24, an in-service distribution may be permitted if an employee has been a participant in the plan for five years, or funds have been in the plan for a two-year period. This is known as the five-year/two-year rule.

If either of these requirements is satisfied, and a plan permits a distribution, in-service distributions can be made for matching and profit sharing contributions. A Roth IRA rollover cannot, however, happen under the five-year/two-year in-service distribution rule for employee pre-tax salary deferral contributions.

In anticipation of employee questions, HR professionals are encouraged to review their qualified retirement plans and determine if in-service distributions are currently permitted and if a plan can be amended to allow such a distribution to occur.

In all likelihood, employers using simple standardized adoption agreements for prototype plans will not be able to effectuate this change. Employers using nonstandardized adoption agreements, volume submitter plans and individually designed plans may execute new adoption agreements and/or amendments to implement such a provision. In any event, HR professionals should carefully consider whether or not adding such a provision is desirable, since assets will be removed from the protection of an employer-sponsored plan.

Conversion inside of a 401(k)

Lurking in the background is potential legislation that would allow a Roth conversion to occur inside a 401(k) plan. Under this legislation, an employee's traditional pretax salary deferral and other contributions could be converted within a 401(k) plan to a Roth 401(k) account. If this legislation is enacted, the need to implement in-service distributions in accordance with Rev. Rul. 68-24 will not be required. Employers are encouraged to carefully consider this matter and the legislation before employee questions commence.

Frank Palmieri can be reached at fpalmieri@p-ebenefitslaw.com.

Any advice in this summary concerning a federal tax issue is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding any tax penalties that can be imposed by the Internal Revenue Service, or for promoting, marketing or recommending any tax-related matters addressed herein in accordance with IRS Circular 230.

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