Roth 401(k)s gained flexibility in the new American Taxpayer Relief Act of 2012 (ATRA12). The new law will allow intra-plan Roth conversions, regardless of whether you’re eligible for a distribution out of the plan. In the past you could convert a 401(k) plan only if you were eligible to take a distribution from the plan. Eligibility generally means you have reached age 59 ½ or met any of the other rules for exclusion, unless your company allows in-service withdrawals. The new rule allows the intra-plan Roth conversions for any employer sponsored plan: 401(k), 403(b), and 457 plans.
The transaction will be taxed just like any other Roth conversion. After the conversion, the funds grow tax-free inside the account. Employees who are in lower tax brackets now can potentially reap big tax savings from such transfers when they retire. Future contributions are made after-tax. By contrast, employees make pretax contributions to a traditional 401(k) plan. The investment return is tax-deferred while the money remains in the plan. However, the money is taxed when distributed at retirement.
This is an important new tool employees can use to build the New Three-Legged Stool™ for retirement. By converting funds from a 401(k) plan to a Roth 401(k) plan, employees can balance the need for tax deductions today with the future need for tax-free income. A tax efficient approach to retirement planning is the sensible way of accumulating assets for the future when our government is running trillion dollar deficits. No one wants to save all of their retirement funds in a tax-deferred plan, only to find out tax rates are higher when they’re ready to retire.
Current surveys say more than 40 percent of employers offer a Roth 401(k) plan feature. The new flexibility offered in ATRA12 could encourage more employers to add a Roth feature to their company’s plan.