The In-Plan 401(k) Roth Conversion Strategy
JAN 3, 2014
Presto! Turn your pre-tax 401(k) into a Roth 401(k). It's done via an in-plan Roth conversion (also known as an in-plan Roth rollover). It used to be that just a handful of employees could make this bold tax move to build a tax-free retirement kitty, but thanks to an expanded law in 2013 and new Internal Revenue Service guidelines out last month, the opportunity is opening up to more workers.
Now that the guidance is out, this is going to be a 2014 initiative for employers,” says Alison Borland, vice president of retirement solutions and strategies for Aon Hewitt. In a survey of 400 employers representing over 10 million employees last fall, Aon found that over the last six years, the percentage of employers that allow Roth contributions (a prerequisite to allowing in-plan conversions) has increased from 11 percent to 50 percent. And 27 percent of those plans that allow Roth contributions allow in-plan Roth conversions. Another 16 percent of companies were planning to add the conversion feature within the next 12 months.
The upside of the Roth 401(k) is years of tax-free –instead of tax-deferred--growth. The downside is you have to pay the income tax on the amount you convert upfront—with a pretax 401(k) you pay income tax when you take the money out in retirement.
So the in-plan conversion strategy is an especially smart move for high-net-worth individuals who don't need all the money in their 401(k) for retirement expenses but want to grow it as an income-tax-free inheritance for their spouse and/or kids. But a conversion can also work well for someone who is young and in a low tax bracket-- if the money will be needed in retirement, it's years away.
Basically, what you do (if your employer allows it) is redesignate money stashed in your traditional pre-tax 401(k) into Roth money, keeping it in the 401(k). In the fall of 2010 Congress allowed this but just for 401(k) money that was “distributable.” That varied by employer, but typically meant your vested balance once you reached 59.5 or retirement age, and in some cases employer match money. Then with the American Taxpayer Relief Act, Congress said that as of Jan. 1, 2013, you could convert everything, including pre-tax salary deferrals, at any age. So you can Rothify your whole account. Or you can Rothify part of it to spread the tax bite over a couple of years.
Once your 401(k) is converted to a Roth 401(k), future earnings grow tax free. So the younger you make the move, the more years of tax-free compounding you get. But here’s how you can really make out. When you leave your employer, you can roll over the Roth 401(k) to a Roth IRA (make sure you make the switch by what’s known as a direct trustee to trustee transfer so you never get a distribution check). You can leave the Roth IRA to your spouse, who doesn’t have to take the money out, and your spouse can leave it to your kids, who will get to dribble the money out over their lifetimes based on IRS life expectancy rules.
Say an employee retires at 62 and rolls his Roth 401(k) into a Roth IRA, and leaves it when he dies at age 80 to his wife, then age 78. When she dies at age 90, she leaves it to their daughter, then 60. That’s 30 years of tax-free growth from when the employee was 62 until his wife was 90. “That’s pretty nice!” says Joseph Urwitz, an employee benefits lawyer with McDermott Will & Emery in Boston. And another 25 years or so of tax-free growth until the account balance is fully distributed at the daughter’s death. (An Obama Administration proposal requiring non-spouse heirs to deplete inherited IRAs within 5 years would limit this third leg of tax-free growth.)
One factor that could push you towards a conversion is if you have deductions to offset the tax cost of the conversion. Scott Kaplowitch, a CPA with Edelstein & Co. in Boston, had a married client in his early 70s with high medical expenses (nursing home costs) do a conversion. The medical expense deduction cut the tax bite, and the client's younger wife hopefully has many years of tax-free growth ahead of her. “It's a longevity play,” Kaplowitch says, noting that the analysis has to take into account your age, your health, your tax bracket, whether you need the assets, and whether you might leave the money to charity.
There are some tricky points to watch out for. The IRS guidance, In-Plan Rollovers To Designated Roth Accounts In Retirement Plans, says that only vested amounts can be converted, says Urwitz. (All of your salary deferrals are immediately vested, but employer contributions are typically subject to a vesting schedule, meaning the money isn't really yours until a certain number of years of employment has elapsed.) Employers can also place limitations on who can convert—such as active employees only. Another warning: just because you’ve converted the pre-tax money into a Roth, you can't suddenly withdraw it, notes Urwitz.
The in-plan Roth conversion rules apply equally to 401(k)s, 403(b)s, thrift savings plans and 457(b) plans.