New 401k Provisions in the Fiscal Cliff Deal: Converting to a Roth 401(k)

Scott Price, CPA

In addition to the more publicized tax hikes and provisions included within the Fiscal Cliff Deal (formally known as the American Taxpayer Relief Act of 2012) there is also an interesting provision for 401(k) plans.  Specifically, the bill has removed certain restrictions regarding the conversion of traditional 401(k) accounts to Roth 401(k) accounts, making it significantly easier for employees to move their retirement assets.

Previously, one of three scenarios had to occur to qualify for a conversion:

  • Change of job
  • Retirement
  • Reaching the age of 59 ½

Now, 401(k) participants are eligible to convert their traditional 401(k) into a Roth 401(k) at anytime.

The motivation behind this particular feature of the legislation is to create additional tax revenue for the federal government.   Converting from a traditional 401(k) to a Roth 401(k) creates a tax liability for the participant due to the “pre-tax” nature of a traditional 401(k) vs. the “post-tax” nature of a Roth 401(k). Participant elective contributions withheld from an employees’ pay for a traditional 401(k) are excluded from taxable wages.  Therefore, if an election is made to convert to a Roth 401(k), the employee must pay taxes on the value of their converted balance.  The federal government anticipates that the decreased restrictions, coupled with historically low tax rates, will entice more 401(k) participants to convert their plans and provide additional tax revenue.

Why will plan participants want to convert? The benefit of a Roth 401(k) is that all future earnings are non-taxable: years of growth can accumulate and be withdrawn as tax-free income. Additionally, with the current tax rates near all-time lows, most participants could make the conversion and pay a minimal tax liability, depending on their tax bracket.

Will this new opportunity create pressure on employers to modify their retirement plans to include Roth 401(k)s?   The Wall Street Journalreports that less than half of companies offered a Roth 401(k) option in 2012, and participation in those plans was minimal.  However, Roth 401(k) plans will continue to be part of the retirement conversation as an important tool to help employees save.  While it is not a mandated offering, your company may want to consider providing a Roth 401(k) option to provide additional flexibility and retirement assurance to employees and as a draw for potential hires.

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