American Taxpayer Relief Act of 2012, fiscal cliff legislation, and in-plan Roth conversions

Effective January 1, 2013, the recently negotiated and signed American Taxpayer Relief Act of 2012 includes provisions for in-plan Roth conversions. The new provision is akin to the in-plan Roth rollover, with the difference being that the provision is applicable for amounts that are not currently eligible for distribution. The legislation benefits plan sponsors and participants but it also provides a revenue stream for the federal government.

Roth contributions to a qualified 401(k) or 403(b) plan or to a governmental 457(b) plan are made on an after-tax basis. This means participants pay taxes on contributions now, not later. Before the new rules, if a plan permitted an in-plan Roth “rollover,” then a participant could move money from a non-Roth plan account (pretax salary deferrals, employer match, employer nonelective contributions) to the Roth account within the same plan. Participants were only allowed to do this if they had distributable events (i.e., distribution at age 59½, severance from employment) and the amount was eligible for rollover. Under the new law, if a plan permits an in-plan Roth “conversion,” then a participant may move money from a non-Roth plan account to the Roth account within the same plan, without having a distributable event.

If participants decide to take advantage of an in-plan Roth conversion, they will pay income taxes at their current tax rates. The conversion is not subject to mandatory or optional withholding, nor to the early 10% penalty tax, although a recapture rule may apply a 10% penalty if in-plan Roth amounts are distributed within a five-year period. This means the participant needs to think about the following: Is my tax bracket at retirement going to be higher than it is now and do I have the money outside of my plan assets to cover the taxes?

If participants expect to remain in the same tax bracket for the remainder of their working careers, there is no advantage to paying the tax now. However, for participants who believe they will be in higher brackets as they go through their working careers and in retirement, and have other money available to cover the income tax, then conversion of a non-Roth account may be beneficial. The converted amount would be considered tax-free, as are the future earnings on it, if certain requirements are met, including a five-year holding period. If the participant will cross multiple tax brackets, it may be beneficial to spread the Roth conversions over multiple years. This helps the participant accumulate resources to pay the taxes and makes the conversion more affordable.

There are additional questions and considerations the participant needs to address, such as when to retire, whether to work after retirement, how much money will be needed in retirement, whether estate taxes must be paid, and how much Social Security provides. These are not easy questions to answer, but taxes and taxable income may impact the answers. Most participants want to maintain a standard of living in retirement that is not less than what they currently have. Considering after-tax investment vehicles, such as a Roth account, may help participants achieve their financial retirement goals.