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Fiscal cliff deal allows more Roth 401(k) switches

NEW YORK — U.S. workers willing to take tax pain today in exchange for tax-free gains on earnings in their 401(k) retirement accounts later have a new avenue to do so.

The fiscal cliff-related budget legislation lets 401(k) participants convert any money in their tax-deferred accounts to a Roth 401(k) account, if their employer offers one, which can be withdrawn tax-free in retirement. The change is projected to raise $12.2 billion in revenue over 10 years, according to the Joint Committee on Taxation, and help defray the cost of delaying spending cuts that had been set to take effect this month.

"This dramatically expands the number of participants who can use this provision," said Bob Holcomb, executive director of legislative and regulatory affairs for JPMorgan Chase's retirement plan services. "It will allow any amount to be transferred."

The conversion opportunity can benefit people with significant balances, the up-front money to pay taxes now with funds outside their retirement account and years of tax-free earnings ahead of them or their heirs. Conversions to Roth 401(k)s had been limited to certain funds and to plans that allowed the switches. The law opens the opportunity to more workers who hold $5 trillion in employer-sponsored defined contribution plans including 401(k)s.

Contributions to a traditional 401(k) account are tax- deferred, with taxes paid at ordinary income rates when the money is withdrawn in retirement. When savers put money into a Roth 401(k) account, they pay taxes on the money upfront in exchange for tax-free withdrawals later.

The new conversion opportunity may help wealthy investors who want to leave their retirement accounts to heirs and younger savers, said John Olivieri, a partner in the New York-based law firm White & Case LLP.

"This is really a huge benefit to heirs," Olivieri said. "Basically you can pay tax now for your kids."

Younger investors may wish to convert a portion or all of their account if it's a small part of their net worth because they have more time to make back the money they lose in paying the tax up front, Olivieri said.

The budget legislation may encourage more employers to offer Roth 401(k) accounts, even as questions remain about the logistics, Ed Ferrigno, vice president of Washington affairs for the Plan Sponsor Council of America.

"This isn't going to happen overnight," he said. "Treasury is going to have to issue guidance. Plans are going to have to make amendments."

A taxpayer in the top income bracket with a 401(k) worth $1 million may pay 39.6 percent, or $396,000, in federal taxes this year when converting the entire account into a Roth 401(k). The legislation allows all or a portion of funds in an account to be converted to a Roth within the same plan, Olivieri said. Once the taxes are paid upfront, all of the additional earnings and appreciation in the account are tax-free, he said.

The scope of possible conversions may be small at the start for 401(k) plans because only about half of employers in 2011 offered Roth accounts in their plans and most of those didn't allow conversions, according to mutual fund giant Vanguard.

"The thing to keep in mind is that when people do that type of conversion they have to pay a tax," said Jean Young, senior research analyst at Vanguard's Center for Retirement Research. "When they realize they have to pay the taxes they tend to back off."

A Roth conversion works best when an investor can pay the taxes with funds outside the 401(k) so as not to deplete savings in the account, said John Sweeney, executive vice president of planning and advisory services at Fidelity.

Investors who are near or at retirement with a 401(k) balance that is a large portion of their net worth that they need to spend in their remaining years rather than transfer to heirs shouldn't make the conversion, Olivieri said.

Fiscal cliff deal allows more Roth 401(k) switches 01/05/13 [Last modified: Saturday, January 5, 2013 3:31am]
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