ATRA – Roth Conversion and the 401(k)

Congress passed an important tax relief package earlier this month called the American Taxpayer Relief Act (forever known now as ATRA) – in case you hadn’t heard – and one of the more interesting provisions is the ability to do a Roth conversion within a 401(k) plan. 

What

Before January 2^nd, employees were mostly prevented from moving assets from the traditional, pre-tax portion of their 401(k) to a Roth component of the same 401(k) plan.  Yes, it was available to those employees who otherwise were eligible to take a distribution from the plan but that was rather limited. With the passage of ATRA, though, Congress has now opened up the opportunity for anyone to move assets from the traditional, pre-tax portion of the 401(k) plan to the tax-free , Roth portion of their 401(k).  In the financial community, the process of moving assets from a traditional account to a Roth account is called converting (aka, a Roth conversion).  

To be clear, it is not as simple as simply moving assets from the traditional 401(k) account to the Roth account.  In order to do this, you have to pay taxes – at your current income tax rate – on however much you convert.  But the end result is that the assets will now grow tax-free and will be distributed income tax-free (under most circumstances). 

Impact

The impact on this is probably fairly limited to most people – or at least it should be.  However, the obvious segment of the population that this benefits are those young people – likely still in their 20s or early 30s – who are still on an upward trajectory in their career paths , have some savings in the traditional 401(k) plan and also aren’t already in a high tax bracket that they anticipate will fall in retirement.   

In other words, it makes sense for people who expect to be in a higher tax bracket in the future when they start taking distributions from the account. 

Planning

So ATRA opened up the possibility for people to move assets from the traditional 401(k) to the Roth 401(k), should you do it?  It depends really on two factors one of which is a complete unknown for most:

      

      1)      Do you expect to be in a higher tax bracket in retirement than you are now?  If the answer is yes, then you should convert assets now as long as you can answer yes to the next question.

      2)      Do you have the cash to pay the taxes today – or technically next year on April 15^th?  You see in order to convert the assets from the traditional account to the Roth account you have to pay income taxes on it today. 

For parents of young adults who see the value in the Roth account and have the cash available to help their children, this may be a very good opportunity. Talk to your adult children about the opportunity, get an understanding of their current tax picture, and know how much they may have in their 401(k).  If they have a lot – or more than you are willing to gift them to pay the taxes – then consider advising them to do a partial conversion.  In other words, if they have $25,000 in the traditional IRA and you only wanted to give them $2,000 to pay the taxes then figure out how much $2,000 will convert – or ask your financial professional to assist you.