A little-noticed feature of the fiscal cliff tax deal could benefit many employees who have traditional 401(k) retirement plans. The provision in the new law allows employees to convert pretax assets in those 401(k)s to Roth 401(k) assets, which could mean years of permanently tax-free growth of those assets. The new rule also applies to 403(b) and 457(b) plans.
About half of employers that offer traditional 401(k)s—which require you to pay taxes once you withdraw the money but not when you first contribute it—also offer Roth 401(k)s. Because of the new rule change, it’s likely that most of them will amend their plan rules within a few months to permit conversions to Roth 401(k)s, which require you to pay taxes when you contribute the money but then allow it to grow without facing taxes ever again, even when you withdraw it.
Prior to the new law, conversions to a Roth 401(k) were allowed only when the assets were “distributable,” which generally meant when you changed jobs, retired or reached age 59½. The new rules don’t have such restrictions.
The amount that is converted from a traditional 401(k) to a Roth 401(k) is taxed as ordinary income for the year in which it is converted.
WHO SHOULD CONVERT
Roth conversions generally make the most sense for people who expect to be taxed at a higher rate when they eventually withdraw money from a retirement account. This might be the case if your income is unusually low during the conversion year…if your career is just getting started and so your income and tax rate will likely grow for many years…or if you believe the government is likely to increase your tax rate in the future.
Conversions tend not to be worthwhile for those who will retire and start withdrawing assets from the account within five years or so, though there’s an exception to this—a Roth 401(k) conversion can be a useful estate-planning tool for high-net-worth individuals even if retirement is looming or already under way. Your heirs can receive tax-free dollars when they inherit your Roth.
For most people, it is prudent to keep significant assets in traditional 401(k)s and/or IRAs but convert a portion to a Roth if you don’t have sizable Roth 401(k) and/or Roth IRA savings already. That way you will have pools of both tax-deferred and tax-free savings to draw from during retirement.
How much to convert depends, in part, on the following…
• How much you can afford to pay in extra income tax during the conversion year without tapping tax-advantaged accounts to help pay those extra taxes.
• How much you can convert before a portion of the extra “income” that the converted amount represents would be taxed at a higher rate because it puts you in a higher tax bracket.
IRA VERSUS 401(k) CONVERSIONS
A conversion to a Roth 401(k) has a significant drawback in comparison to the conversion of a traditional IRA to a Roth IRA. When you convert an IRA to a Roth, you have the option of “recharacterizing” the conversion, essentially undoing it, by October 15 of the year following the year of the conversion. Recharacterization currently is not an option with Roth 401(k) conversions.
Example: If the IRA assets you convert decline sharply in value soon after the conversion, you could recharacterize them back to a traditional IRA, wait out an IRS-imposed waiting period, then convert the assets to a Roth again—this time paying taxes only on the now much-lower asset value.