‘Fiscal Cliff’ Legislation Expands Opening for Switching to a Roth 401(k)

As Congress placed the final pieces into the bill that would become American Taxpayer Relief Act (ATRA), to resolve the so-called “fiscal cliff,” it included one less-publicized item that could be very important to many retirees. That provision expands the number of people who have the option to convert their retirement savings into a Roth 401(k), USA Today recently reported.

The new rules allow the option of a Roth conversion for workers of all ages. Previously, Roth conversions were limited to retirees or workers age 59½ or older. Workers below that age could only make new contributions to a Roth 401(k), or move their 401(k) into a Roth IRA if they left their jobs.

Roth 401(k) plans combine a unique mixture of features of Roth IRAs and a traditional 401(k) plans. Roth 401(k) plans are provided by employers like regular 401(k) plans, but allow employees to fund them with after-tax contributions, like a Roth IRA. The hope is that the expanded availability of Roth conversions will serve as a “win-win.” It allows consumers who desire to grow at least part of their retirement savings tax-free forever, while also functioning as a revenue-generator for the government. Observers expect the new, expanded conversion option to generate more than $12 billion in tax revenues over the next decade.

The major drawback to making such a conversion is the substantial up-front cost. Plan participants making the conversion face a significant tax liability in the year they switch, meaning they must have the available resources to pay that tax bill. However, plan participants who fear massive tax bill can defray part of that liability by choosing to do only a partial conversion.

Another hurdle exists for some other employees, depending on the specifics of their 401(k) plan. The new option’s advantages are only available if your 401(k) plan has a Roth 401(k) option and permits converting your 401(k) to a Roth. This eliminates many employees. An Aon Hewitt survey revealed that, in 2011, only 40% of 401(k) plans included a Roth 401(k) option, although Aon Hewitt reported that a recent informal survey indicated that that number had increased to half of all plans.

The Roth option appears particularly appealing to younger workers, who fear that their tax rates in retirement will exceed the current rates. A Wells Fargo study from late last year showed nearly 15% of Generation Y plan participants currently contribute to a Roth 401(k), while that number is only about 6% for Baby Boomers. The benefits of a Roth conversion are not limited solely to younger workers, though. Older workers might also elect to make the switch to a Roth if they believe that their tax burdens might climb in the years ahead.

With the enactment of new laws, new avenues exist for saving for retirement. With each option comes it own set of advantages and drawbacks, including the tax ramifications of these choices. To discuss your options, and their financial effects, consult the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C., who have been helping people throughout New York and northern New Jersey for years in dealing with retirement accounts and tax issues related to those accounts. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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