February 2013

With the government perspective that obtaining tax dollars now is good and we can worry about later…well later, the American Taxpayer Relief Act of 2012 allows workers with regular 401(k) account balances to move them into a Roth 401(k).  The conversion allows a shifting of the timing (and generally the amount) of taxes ultimately paid because of key difference between the two plans.

With a regular 401(k), you pay no income tax on plan contributions into the account, and the money grows without current taxation. However, when the money is removed, every dollar you take out is taxed as ordinary income, including moneys that might otherwise get favorable dividend or capital gains taxation. In contrast, with a Roth 401(k), you pay tax on money that goes into the account, but it grows tax free and remains tax free when you remove it from the plan, as long as (i) you had the account for more than five years and (ii) you are at least 59 ½, dead, or disabled.

Stated otherwise, in a Roth conversion now allowed by the American Taxpayer Relief Act of 2012, account holders have to pay the additional taxes now (an estimated 12.1 billion in tax over the next 10 years), but all future appreciation in the asset balance would then be tax free. Long-term, allowing the Roth option will cost the U.S. government plenty.

Of course, the sponsoring employer needs to include a Roth option in their plan, an option that has been available since 2006. Conversion of regular to Roth 401(k) balances has been allowed since 2010 under limited circumstances, under what is called an in-plan conversion. The current change makes the conversion simpler, and more accessible under many plans. Previously, conversion rules generally required you be eligible to take funds out of the account.  Some employers remained surprisingly slow to add this option to their plan, despite the relatively low cost of amending a plan to include a Roth option and the substantial benefits to workers desiring this opportunity.

None of this is to say that a conversion should be undertaken without careful consideration of the implications. Generally, conventional wisdom suggests one should convert to a Roth 401(k) if tax rates are expected to be higher in retirement than currently.  Since one cannot know with certainty what future tax rates will be, there is an inherent risk that either tax rates or an individual’s circumstance will differ from current expectations.

One might assume that there is little incentive toward a Roth 401(k) for those in the top tax bracket, but retirement tax rates are not always lower for these individuals. The additional income from retirement investments may keep an individual in the highest tax bracket even when other earnings subside.  Additionally there is a real possibility that tax rates for the affluent will increase. However, even putting aside these possibilities, there are other considerations that could provide strong incentives for the affluent to take advantage of this 401(k) conversion option.  These include:

  1. The tax equivalency assessment assumes the taxpayer reduces the amount invested by the taxes which are paid currently. As a result and all things equal, the Roth 401(k) conversion protects a greater amount of purchasing power from creditors, as money that will be distributed tax free is worth more than that which will be taxed.
  2. Because regular 401(k) distributions are part of the income base used to determine whether Social Security benefits are taxed, the Roth account does not worsen the challenge of keeping Social Security benefits from being taxed.
  3. The prepayment of tax liability under a Roth 401(k) can be an estate planning tool, allowing for tax free transfer to heirs.

Identifying the best place for an individual’s retirement funds is a nuanced decision.  While the Roth advantages provide an overall benefit even if future tax rates are slightly lower, the opposite is true if the taxpayer’s future tax rate is expected to decline substantially.

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