GOLDEN VALLEY, Minn. - A component included in the new bill passed to avert the 'fiscal cliff' is a provision allowing retirement plan investors the opportunity to convert traditional 'pre-tax' balances to a Roth 401(k) within their retirement plan.
While the allure of tax-free growth may be top of mind, it is also equally important to evaluate the costs and appropriateness to your specific situation.
With his weekly visit, Dan Ament, Financial Advisor with Morgan Stanley in Wayzata, talked this new option available to retirement investors and some of the potential pros & cons.
More 401(k) savers eligible to convert to Roth
The new legislation expands a 2010 law that gave workers investing in 401(k)s the ability to roll certain available funds to Roths. Now - workers of any age or employment status can move pre-tax savings to a Roth account within their employer plan if available.
Benefit to investors - After paying an up-front tax bill, future earnings and retirement withdrawals are generally tax-free.
Benefit to the government - According to the Joint Committee on Taxation, Congress estimates the new Roth provision will raise $12.2 billion in revenue in the next decade.
Who should consider it
The biggest potential beneficiaries of converting and paying tax now are people who expect to be in a higher tax bracket later in life. This often includes those how are younger, earlier in their careers and not at their peak earnings. It may also include those who have sufficient retirement assets for their own needs that desire to set aside a piece of their portfolio intended for their heirs on their passing.
The amount converted is taxed as ordinary income, meaning a potentially large tax bill would be due the following April.
Higher tax bracket?
The added income from the conversion could bump you into a higher tax bracket.
Your plan must allow for it
Your retirement plan must allow Roth contributions as well as allow for 'in-plan conversions'. According to Vanguard, about 46% of 401(k) plans they administer offer a Roth option yet only 9% of the participants who had access to the Roth feature utilized it.
No re-characterization option
Conversions of pre-tax balances to a Roth 401(k) cannot be undone. This is in contrast to the option available to those who convert traditional IRAs to a Roth. In that case, you can choose to 're-characterize' or undo your conversion in the event you can't cover the tax liability or if the value of your investment assets has fallen in value making it less appealing to proceed with the conversion.
Spread it out
If you desire to convert your pre-tax retirement plan to a Roth 401(k), one strategy to use is to convert a smaller piece of your balance each year, thus averaging out the tax bite.
Bottom line? While a Roth conversion may be appropriate for certain investors, it is important to seek the advice of your tax advisor before presuming that a Roth conversion is right for you. Given the hurdles indicated above, it is not a decision to take lightly.
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