Uncover Key Change for Roth 401(k)s
It has not received much attention in the media, but a “hidden” provision in the new American Taxpayer Relief Act of 2012 (ATRA) creates a new tax-saving opportunity for retirement-savers. As a result, you may be encouraged to transfer funds to the Roth version of a traditional 401(k), if it is offered by your employer.
Background: As with a traditional 401(k), contributions to a Roth 401(k) up to the allowable limit (see chart below) may compound on a tax-deferred basis over time, although contributions are not made with pretax dollars like they are with traditional 401(k) accounts. The main benefit comes when you receive the money in retirement. As long as the Roth 401(k) has been in existence at least five years, qualified distributions (e.g., those made after age 59½) are completely tax-free.
Furthermore, unlike regular 401(k) accounts, there is no income limit on your eligibility to contribute to a Roth 401(k). This makes it an attractive option for upper-income employees.
Hidden new rule: Beginning in 2013, you can convert 401(k) funds to an employer-sponsored Roth 401(k) account whenever you choose. Previously, you had to be eligible for a distribution, usually upon attaining a certain age or leaving the company. In other words, ATRA gives you the chance for in-service conversions. Of course, the switchover is still a taxable event, but it could be worthwhile if you expect to be in a higher tax bracket in retirement.
Suppose Ivy Adams, age 50, has $200,000 in her traditional 401(k) account. For simplicity, let’s say she converts the entire $200,000 to a Roth 401(k) in 2013 and pays an effective federal income tax rate of 28%. (The actual tax rate will depend on other circumstances.) Therefore, Ivy pays $56,000 in tax on the conversion. But if she waits 10 years to begin withdrawing funds from the Roth 401(k), Ivy will owe zero tax on her qualified distributions—even if the account grows to $1 million or more.
In comparison, if Ivy accumulates say, $1 million in her account and withdraws it all in her sixties when she is in the 35% tax bracket, she will owe $350,000 in tax—almost $300,000 more than the amount she has to pay up front with a conversion. Conversely, if Ivy expects to be in the 25% tax bracket when she begins taking withdrawals from the Roth 401(k) and she is forced to dip into those funds to pay the current conversion tax, this option may not be the best approach for her.
Finally, keep in mind that you must begin taking “required minimum distributions” (RMDs) from any 401(k) after reaching age 70½. However, if you have a Roth 401(k), you can roll over the funds to a Roth IRA tax-free. There is no requirement to take lifetime RMDs from a Roth IRA. Coordinate such techniques with other retirement planning aspects.