Plan Sponsors: Offer Participants Tax Diversification Through Roth 401k In-Plan Conversions
By Michael J. Francis, CIMA®, JD, President & Chief Investment Officer at Francis Investment Counsel.
Roth 401k accounts have been around since 2006, but are expected to become increasingly popular due to the passing of the American Tax Payer Relief Act 18 months ago.
This recent change in tax law enables retirement plan participants to convert any or all of their pretax vested plan assets -- participant and employer contributed -- into a Roth account.
Currently, only about half of employers offer a Roth 401k provision. However, adding this benefit to your existing 401k or 403(b) plan will hardly cost you, your plan, or your employees anything. It is a minor administration change that could potentially make a huge difference in how much your employees have available at retirement.
A Roth account allows eligible retirement plan participants to save after-tax money for retirement and withdraw all Roth assets -- both contributions and earnings -- tax-free in retirement, as long as they are 59½ or older and the Roth account has been established for at least five years.
While the upfront tax break has always been one of the most attractive features of saving in a traditional 401k account, a Roth account that allows for the tax-free compounding of all earnings could end up being an even better deal for employees.
The biggest hurdle converting to a Roth is that participants must pay ordinary income tax on the amount converted and generally cannot use plan assets to pay the tax.
So, which participants could benefit from taking advantage of the new Roth in-plan conversion rule? Here are a few of the most compelling examples:
Young savers: Many young participants are just starting out in their career, they are likely in a lower tax bracket and have a smaller account balance. Converting some or all of their existing pretax account will set them up for more than 40 years of tax-free compounding. They need to be aware that the move does not bump them into a higher tax bracket.
Someone saving for somebody else: Assets in a Roth account are bequeathed income-tax-free to a spouse or the next generation. This right allows the recipient to extend the tax-free compounding for many more years.
Someone with a lot of deductions or a large loss: If a participant finds him or herself with a large tax deduction such as a business loss, charitable contributions, or even medical expenses, the taxable income generated by an in-plan Roth conversion is a creative way to fully utilize some or all of these deductions. A sudden drop in your 401k account value (think 2008) might also present a window of opportunity to convert to a Roth, pay taxes on a greatly reduced amount, and then withdraw the resulting rebound tax-free years later.
Someone concerned about being in a higher tax bracket in retirement: Many American workers today find themselves in a historically low tax bracket. So encouraging these employees to pay taxes on their retirement savings at today’s low rate hedges the possibility of higher tax rates in the future.
Action steps: First, while Roth in-plan conversions are part of the new IRS rules for retirement plans, they are not automatically available to everyone. As an employer, you must amend your plan to allow for them.
Final thoughts: The new Roth in-plan conversion rules apply equally to 401k, 403(b) and government 457 retirement savings programs and underscore the importance of proper planning.
Used properly, a Roth in-plan conversion is a powerful new tool that can help participants achieve their goal of financial security in retirement.
Francis Investment Counsel is a fee-only Registered Investment Advisor dedicated to providing independent investment consulting and employee education services to the qualified plan marketplace. The company delivers conflict-free investment advisory services to plan sponsors and also offers extensive education and individualized advice services to plan participants.
The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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