Tucked into the recent “Fiscal Cliff” bill (the American Taxpayer Relief Act of 2012) was a provision allowing an individual to convert amounts in their 401(k) plans to a Roth 401(k). Previously, an individual could only convert amounts that were otherwise available to withdrawal from their 401(k), meaning after leaving their job, retiring, or reaching age 59 ½. Under the new rules, as long as Roth contributions are offered by the employer’s 401(k) plan, employees can convert amounts while still employed, and at any age.
As my colleague mentioned last week, the income limitations on Roth IRA conversions (moving qualified retirement plan or traditional IRA assets into a Roth IRA) were removed beginning in 2010. That change opens the door for all taxpayers to take advantage of the Roth IRA – specifically the tax-free growth (as opposed to tax-deferred in a 401(k) or traditional IRA) and the lack of required minimum distributions (RMDs). You pay the tax once on conversion to move those pre-tax assets into post-tax assets, and then (after meeting the age and time requirement) any future distributions are 100% tax free, including all future earnings as long as you live.
Current Roth Contributions
Even though the income limitations on Roth conversions were lifted, the income limit on annual Roth contributions is still in place ($105,000-$120,000 for single taxpayers, $167,000-$177,000 for married taxpayers). That keeps annual Roth contributions out of reach for higher-income individuals.
There is another option, however: starting in 2006, employers were allowed the option of including a Roth component of their 401(k) plan – called a Roth 401(k). The contribution limits are the same as a regular 401(k) ($16,500 in 2010), but instead of getting a tax deferral on the amount (the contribution is excluded from your pay and taxed later during your retirement); the amounts are taxed currently and can be distributed tax-free in the future, just like a Roth IRA. This is a great option for a taxpayer who earns too much to be eligible for Roth IRA contributions, but wants to take advantage of the tax-free growth. One other note: employer contributions cannot be allocated to the Roth account – those are still taxable on withdrawal.
The catch is that the Roth 401(k) is not exactly like a Roth IRA. We already know the annual contribution limits are higher, which is an advantage. And the Roth 401(k) is not restricted by income limitations—another advantage.