Converting 401(k) assets to a Roth account became easier with the passage of The American Taxpayer Relief Act of 2012 (ATRA).
The ability to contribute to a Roth account in a 401(k) and 403(b) plan has been allowed ever since 2006. However, plan participants were not able to convert their traditional pre-tax portion of their retirement plan to the Roth portion of the plan until the passage of the Small Business Jobs Act (SBJA) in 2010.
The problem was that SBJA only applied to intra-plan conversions by participants who were eligible to take a distribution from the plan. Such distributable events include reaching the age of 59½, separation from service or retirement. Therefore, relatively few participants were able to take advantage of an in-plan Roth conversion. ATRA now allows intra-plan Roth conversion without the requirement for a distributable event. In order to take advantage of this opportunity, the employer-sponsored plan would specifically have to permit Roth contributions and may need to be amended to include language allowing for intra-plan conversions. Additional guidance on this is expected from the Internal Revenue Service later in the year.
This new provision is being touted by the Congressional Budget Office (CBO) as a $12.2 billion revenue raiser over the next 10 years. It is believed that taxpayers will be attracted to the idea of paying taxes now on assets that have the potential to subsequently grow on a tax-free basis. Before taking advantage of this opportunity, plan participants should first discuss with their advisor whether and how much of their retirement assets should be converted to a Roth account.
The factors to consider when converting retirement assets to a Roth includes the participants’ investment timeline, whether they have assets to pay the resulting income taxes, their current income tax bracket and whether they believe income tax rates will be lower or higher in the future. Whether a Roth conversion makes sense will depend on some of these factors, as well as the individual’s specific financial planning goals and objectives.
With recent years of tax uncertainty, there has been a greater focus on the benefits of tax diversification. The idea being that having investments in different buckets – those that are taxable, tax-deferred and tax-free – allow for better tax efficiency and control of a person’s tax liability when taking distributions. Allocating a portion of a client’s money into a tax-free Roth account can be an ideal way to provide for this tax diversification.
If a Roth conversion does make sense, the next question is what assets should be converted. First, make sure the employer-sponsored plan permits an intra-plan conversion. Then determine if the participant otherwise has the right to either roll money out of the plan directly to a Roth IRA (rollover conversion directly to a Roth IRA has been allowed since 2008 under the Pension Protection Act of 2006) or have traditional IRA assets that can be converted.
One of the benefits of converting funds to a Roth IRA, as opposed to an intra-plan conversion, is the ability to recharacterize the conversion. If the investments drop in value after the taxpayer converts the funds, the taxpayer has the ability to recharacterize or undo the conversion. It is as if the conversion never happened. The taxpayer can elect to recharacterize a Roth conversion for any reason up until the tax filing due date of their income tax return including extensions (Oct. 15). An intra-plan Roth 401(k) conversion cannot be recharacterized. This can be a major drawback to an intra-plan conversion.
Another key difference between a Roth 401(k) and a Roth IRA is the requirement to take a Required Minimum Distribution (RMD). Roth 401(k) plans are subject to RMDs, meaning that once the participant attains the age of 70½ (or retires if later) the participant must begin to take distributions. The distributions from the Roth account will be tax-free but will lose the benefit of continued tax-free investing. Roth IRAs, on the other hand, are not subject to the RMD rules and can continue to grow tax-free until the death of the account owner. Of course, the plan participant can easily get around this by rolling the Roth 401(k) monies to their individual Roth IRA at or before age 70½.
As more plan sponsors amend their retirement plans to take advantage of new provisions under the recent passed tax act, the more people will be having the Roth conversion conversation. Be prepared to discuss whether a Roth conversion makes sense and, if it does, what retirement assets should be converted and whether that conversion should be inside a retirement plan or to a Roth IRA.