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New Roth Conversion Flexibility

by Mary Stucke

The American Taxpayer Relief Act of 2012 (ATRA) has generated a lot of buzz so far in 2013 but there was one change no one saw coming: ATRA will now allow individuals to convert their existing 401(k) plan into a Roth 401(k) plan.

A Roth 401(k) works in reverse of a traditional 401(k) in that the money you put into a Roth account is after-tax while a 401(k) contribution is tax-deductible but you must pay taxes on any withdrawals.  When you put this after-tax money into your Roth account, withdrawals taken after you reach age 59 ½ will be tax-free if the account has been funded for at least five years.  The prospect of tax-free money during retirement is attractive to investors while prospect of tax dollars getting paid today instead of being deferred is attractive to the government.

Michael Kitces’ Nerd’s Eye View blog does a great job of summarizing this change. Click here for details, or see the quoted text below:

In one entirely new rule under the legislation, ATRA will now allow individuals to convert their existing 401(k) plan to a Roth 401(k) plan, if the employer offers designated Roth accounts under the plan, regardless of whether the individual is allowed to take a distribution out of the plan. The transaction will be taxed in a similar manner to any other Roth conversion. Given the way the rule was written, it’s unclear whether such a conversion could be recharacterized as IRA-based Roth conversions can, although such a “technical correction” could always be added later (and there’s a lot of time to do so, since the deadline for any 2013 conversions of 401(k) plans would be October 2014).

The reason this provision is notable is that, under current law, you can only convert a 401(k) plan if you are eligible to take a distribution from the plan (whether it’s going to a Roth 401(k) or Roth IRA), which generally means you have to be 59 1/2, dead, disabled, or separated from service, unless the plan allows in-service withdrawals. The new ATRA provision will allow an intra-plan Roth conversion, regardless of whether you’re eligible for a distribution out of the plan (the way you would have to be to get to a Roth IRA).

Basically, the new rule simply means you can now do intra-plan 401(k) conversions from traditional to Roth in the same manner you can do so for IRAs. But you still can’t go FROM a 401(k) TO the IRA unless you’re otherwise eligible for a distribution from the 401(k). In theory, the increased flexibility for Roth conversions means more (current workers) will convert their existing 401(k) plans, which provides a short-term revenue increase for the Federal government (thus, this new rule was actually scored as a “revenue raiser” in measuring the fiscal impact of the provision).  Of course, as I’ve written in the past, whether completing a Roth conversion (inside a 401(k) or with an IRA) is a good deal or not depends on several individual-specific factors.

*Thank you to Hallie Frair, Assurance Senior, for her contributions to this post.

This entry was posted in Audit & Tax Talk and tagged Accounting. Bookmark the permalink.

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