ATRA12 Offers New Opportunities for Roth 401(k) Conversions

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401k EggIn the new American Taxpayer Relief Act of 2012 (ATRA12), new taxes on the highest income earners has captured the most attention. However, buried inside the new legislation was a small provision providing greater flexibility for employees to convert to a Roth 401(k). I wrote about it briefly in a blog post on March 8th this year. As the end of the year approaches, this new provision may prove useful to some as part of their year-end tax planning.

The 2010 Small Business Jobs Act (SBJA10) provided the first opportunity for employees to convert some or all of their traditional 401(k) plan to a Roth 401(k). This provision also applies to 403(b), 457(b), and government employees TSP plans. The purpose of the SBJA10 provision was to avoid the step of rolling over your employer plan to an IRA and then converting it to a Roth. Conversions were only allowed after an employee was eligible to take a distribution from their company plan. This was generally at retirement. ATRA12 expanded this provision to allow intra-plan conversions so employees don’t have to wait until they’re eligible to take distributions.

The transaction will be taxed just like any other Roth conversion. Some believe the provision was only added as a short-term revenue raiser for the government. In the long-term this is a revenue loser for the government as earnings post conversion grow tax deferred and will be tax free when withdrawn providing the rules are met for tax-free withdrawals from a Roth IRA. Long-term tax planners should consider converting when they are in a low tax year because they can potentially reap big tax savings from such transfers when they retire.

This is an important new tool for employees who have found it difficult to build money inside the tax-free leg of their 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.

Not all employers offer a Roth component in their company’s retirement plan. Current surveys say only 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. You cannot make an intra-plan conversion unless you company offers the Roth component.

Those employees who can make conversions need to consider this strategy carefully. The thought process is basically the same as when considering an IRA conversion. Time is an important part of the evaluation. The longer money can grow tax-free inside a Roth the better chance you have of making up for the lost taxes paid up front for the conversion. You also need to make sure you will have the money to pay your taxes on the conversion. There may not be enough time left in the year to increase your withholding at work to pay for the entire conversion. You should check with your tax preparer to be sure you have enough taxes paid in to avoid the underpayment penalty.

After the intra-plan conversion, Roth funds grow tax-deferred and can generally be distributed tax-free at retirement. 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. The final question to address is your outlook for future tax rates. Will you be in a lower tax bracket when you retire? ATRA12 is supposed to make tax rates permanent but tax reform has been talked about all year. Paying taxes now on an intra-plan conversion may not make sense if you are in a lower tax bracket at retirement unless the money is in the plan for a long time.

Finally, it is very important to remember you cannot recharacterize an intra-plan conversion. I have often written about Roth conversions and admonished people to convert, even when in doubt, because you could always undo the conversion through a process called recharacterization. Intra-plan conversions are irrevocable! You should only consider intra-plan conversions after you have converted all your IRAs to Roths.

Rick’s Tips:

  • Tax-deferred employer plans can now be converted to Roth accounts even if you are still employed.
  • Intra-plan conversions are taxable in the year they are completed.
  • Intra-plan conversions are irrevocable and not eligible for the recharacterization procedure.

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