OCEAN CITY — In January, Congress passed the American Taxpayer Relief Act of 2012. Along with many much-discussed measures that allowed the government to avert the so-called fiscal cliff, the law contains a less publicized provision revising the rules surrounding Roth 401(k) plans.
On the surface, the new rules provide employees with somewhat greater flexibility. But as with all tax provisions of this sort, there are many moving parts and important caveats for savers and employers alike to consider.
Under the old rules, an employee could convert the vested non-Roth designated account balances in his or her 401(k) plan to a Roth-designated account in the 401(k) plan, only if the plan allowed for Roth-designated contributions as well as in-plan conversions — and only after the occurrence of a “distributable event,” such as leaving the company (for whatever reason) or reaching the age of 59½. Under the new rules, however, as long as the plan has Roth-designated accounts and permits in-plan conversion, a retirement plan participant can convert vested non-Roth designated account balances to a Roth-designated 401(k) account even if he or she has not experienced a distributable event.
Currently, however, only a fraction of the total universe of 401(k) plan participants will be able to take advantage of the freedoms accorded by the new rules. That’s because very few of the 401(k) plans that offer Roth-designated accounts even allow for in-plan conversions—only about 5%, says Laura Grogan-O’Mara, director, legislative and public policy, Global Wealth & Retirement at Bank of America Merrill Lynch.
The reason few plans offer these conversions is that demand from employers and employees has been tepid. Before the American Taxpayer Relief Act, when conversions were allowed only when an employee had a distributable event, the percentage of employees taking advantage of the opportunity, when available, was in the low single digits, according to Aon Hewitt research. Meanwhile, for the plan providers, the recordkeeping involved in facilitating in-plan conversions proved costly.
Additionally, employees who do make a conversion must pay the full tax on the sum being converted in the same tax year. So if you move $10,000 from the pre-tax account in your 401(k) plan into a Roth-designated account in that 401(k) plan in 2013, you’ll need to come up with the cash to pay for the income tax on that $10,000 by April 2014. Luckily, Grogan-O’Mara notes, “you can also convert your balance over several years, in small amounts, so it’s more digestible from a tax liability standpoint.” Another caveat to be aware of is that unlike conversions to Roth IRAs, which may be unwound, or “de-converted,” up to October 15 of the year following the year of conversion, in-plan conversions to a Roth-designated account are irrevocable.
Why would Congress expand a provision that hasn’t been widely utilized? In large part because the new Roth in-plan conversion rules are projected to raise $12 billion in tax revenue over the next decade, according to the Congressional Budget Office.
For now, business owners whose company retirement plans don’t already offer in-plan conversions may want to consider asking about the option in their next round of requests-for-proposals, Grogan-O’Mara says. As a matter of course, she adds, owners should be making such requests of their 401(k) providers every three years or so “just to make sure the fees they’re paying are reasonable and compatible in the industry.” That way, business owners can look holistically at the cost-benefit picture and determine whether it’s the right time to switch.
(The writer is a senior financial advisor and can be reached at 410-213-8520.)