New Rules to Help You Build Your New Three Legged Stool

Building a tax efficient New Three-Legged Stool successfully takes preparation.

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A new feature in the American Taxpayer Relief Act of 2012 allows company plans (401(k), 403(b) and 457(b)) to permit participants to convert pre-tax contributions to Roth account balances. The new provision provides participants with additional flexibility to help reach retirement with a properly balanced New Three-Legged Stool™. Those participants who convert all or part of a pre-tax account are required to pay taxes on the amount in the year of the conversion, just like converting a traditional IRA to a Roth.

Building a tax efficient New Three-Legged Stool successfully takes preparation. Many employees believe saving in an employer-sponsored plan is the easiest way to discipline themselves to put money aside for retirement. Having the ability to save pre-tax and after-tax in a Roth provides a valuable way to save tax efficiently. Conversions may appeal to participants who do not expect their tax rate to be lower in retirement. They may also choose to make the conversion in a tax year which is unusually low for them. The conversion feature should appeal to younger participants who have a lot of time ahead of them, while their accounts can grow tax-free.

Participants should seek qualified tax advice before electing to convert. While conversions are not subject to the 10% early distribution tax, the amount converted is taxable. Unlike converting a traditional IRA to a Roth, the employee cannot re-characterize back to pre-tax if they discover the conversion did not work out the way they planned. Converted dollars are taxed in the year of conversion and cannot be re-characterized later.

You will need to check with your employer to determine if they have elected to adopt this new feature in your plan. The existing plan must allow Roth deferrals. Your company will need to add Roth deferrals before participants may convert any existing balances. If your plan already allows Roth deferrals, it is likely they will adopt the conversion feature.

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