Part of the fiscal cliff deal allows employees with 401(k)s to convert to a Roth 401(k) without issues. However, this wasn't done to help you out; Uncle Sam is looking to pay some bills.
There’s something that came out of the fiscal cliff compromise that flew under the radar.
However, you can see why it came about…
The legislation, produced New Year’s day, included language that lets employees with 401(k)s and other defined-contribution plans convert to a Roth 401(k) without issue.
This wasn’t done to help us out. Uncle Sam is looking to pay some bills. Roth conversions mean an immediate tax hit for the investor. And we’re talking about a lot of money on the table.
According to information released by the Investment Company Institute for the third quarter of 2012, there’s $3.5 trillion in 401(k) plans. The federal government can’t wait to tax it.
What is a Roth 401(k)?
Just like the name suggests, a Roth 401(k) takes the best of both traditional 401(k) plans and Roth IRAs. It’s an employer-sponsored plan using after-tax dollars.
In the case of a Roth IRA, you get the tax break on the back-end. The account grows tax-free and distributions are taken without a tax event if you’re either age 59-and-a-half and/or held the account for five or more years.
The Roth 401(k) can create an opportunity for high-income earners who have been ineligible to contribute to Roth IRAs due to income restrictions. Here are the Roth IRA income limits for 2013:
• For singles: The new phase-out range for 2013 is $112,000 to $127,000.
• For married couples filing jointly: The new phase-out range for 2013 is $178,000 to $188,000.
There are no such income restrictions for Roth 401(k)s. In addition, Roth 401(k) accounts are subject to the contribution limits of regular 401(k)s — $17,500 for 2013, or $23,000 for those 50 or older by the end of the year.
However, remember that these contribution limits apply across the board to all types of 401(k) plans. This means you can’t save $17,500 in a regular 401(k) and another $17,500 in a Roth 401(k). The total of all contributions must not exceed $17,500.
What’s in the new bill?
The new American Taxpayer Relief Act of 2012 allows employees to initiate a conversion of their existing 401(k) plan to a Roth 401(k) plan if the employer offers this as an option.
The new legislation allows you to convert every type of money bucket in a traditional 401(k) — and that includes salary deferrals that have not been taxed yet — and at any age. Rules became effective Jan. 1, 2013 and you can convert 2012 and/or prior year contributions.
The old regulations mandated that retirement plan participants could only make a conversion if they met qualifying events like a termination of employment, retirement, disability or reaching age 59-and-a-half. This is now not the case…
The conversion process hasn’t changed. It follows the same mold of converting a traditional pre-tax IRA to a Roth IRA. Basically, if you believe it’s better for you to pay taxes now rather than later in retirement, you would do a conversion. Roths grow tax-free and the distributions are tax-free.
But just because you can doesn’t mean you should…
When might a Roth conversion make sense?
Here are the four factors to contemplate in deciding if this is the right move for you:
1. If you plan to leave your 401(k) as a tax-free inheritance for your beneficiaries, you may just want to bite the tax bullet now and convert to a Roth. Beneficiaries could take withdrawals without incurring any taxes.
2. You need to decide when you may need the money. If you will need the money within 10 years or less, a conversion most likely won’t make sense. If you have time to retirement, it may be worth your while. It’s a great opportunity for younger employees who can pay the conversion tax out-of-pocket. And this is the perfect segue into the next point.
3. Will you have deductions or tax credits to essentially pay your tax bill due on the Roth conversion? The other option is to have out-of-pocket money to cover the cost. Usually if the investor has to take money out of the account they are converting to pay the tax, it almost never makes sense to do the conversion. The numbers will not add up in your favor.
4. And, finally, you need to make an informed assessment of what your future tax rate will be. The easiest way to do this is putting together your best estimate of future income. It may be worth it if you feel that your tax rates would be higher in the future.
This is not an all-or-nothing proposition
After you discuss the four factors above, keep in mind one thing: Conversion is not an all-or-nothing proposition. You can use a little strategy by converting a part of your 401(k).
Having both Roth and traditional pretax savings allows you a little more flexibility in navigating the ever-evolving tax landscape. As you get older, you may also be able to avoid an increase in taxes on Social Security benefits or increased Medicare premiums by using Roth withdrawals. That could keep your income level down.
Back in 2010, Congress allowed for the expiration of the $100,000 adjustable gross income limit on Roth IRA conversions. That was the end of income limits on Roth conversions while leaving income limits on contributions in place. So it let anyone convert and/or contribute to a Roth IRA.
However, that old law let you split the tax hit over two years. The new legislation doesn’t give you such a feature. You take the entire hit the year you do it. Another feature gone, which gave us more peace of mind, is the process of “recharacterization” — the ability to undo the conversion. Recharacterization gave you the ability to cancel out your Roth conversion in the next calendar year if you experienced a change of heart.
This may seem like a law to just pacify finicky investors, but the lack of this provision could carry some huge consequences.
For instance, employees could find themselves in a world of trouble if they lost their job and were unable to pay the tax hit on the Roth conversion. Or what happens if there’s a Roth conversion followed by a large market downturn? The employee must pay taxes on the original conversion amount even though the present amount could be considerably less. A conversion could come back to hurt you.
You should take all of the above information into consideration if you’re thinking about this option going forward.