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New Rules For Switching To 401(k) Roth Retirment Plan

By: Investor's Business Daily
Posted: 2/15/2013 4:48:00 PM
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While 401(k) retirement plans offer valuable tax deferral, Roth 401(k)s can be tax-free. With the latter, all distributions avoid income tax five years after your first contribution, if you're at least 59-1/2.

The new tax law makes it easier to switch to a Roth 401(k), effective Jan. 1, 2013.

Now, anyone can convert 401(k) funds to a Roth version, at any time. Before, you had to be eligible for a distribution, usually by reaching a certain age or leaving the company.

Here's the catch: You have to pay tax on the amount converted, using your current income tax rate.

The new rules also apply to the Roth versions of 403(b), 457(b), and thrift savings plans. If your employer's plan has a Roth option and if it allows such conversions, you can make the change.

Suppose Art Smith, age 35, has worked at his company for 10 years, building up a $200,000 401(k) balance. Last year, his company added a Roth option. Art can transfer his $200,000 to the Roth version, pay tax upfront, and let the account balance build up for eventual tax-free withdrawals.

If Smith is in the 28% tax bracket this year, a full conversion would cost him more than 28% (or $56,000). He could pay more than $60,000 because adding $200,000 to his income pushes him into the 33% bracket for the year.

Smith's $200,000 in the Roth account, assuming a 5.7% average annual return, might grow to $800,000 when he retires at 60. He can take out all that money tax-free.

If Smith keeps the money in the traditional tax-deferred 401(k) and he's still in the 28% bracket at retirement, he'd pay 28% on withdrawals.

Paying tax now at 28% and 33% in order to avoid 28% tax later doesn't make sense. So when will an in-plan Roth conversion work?

"A conversion can pay off if you believe that you will be in a higher-tax bracket when you take withdrawals," said Richard O'Donnell, tax analyst at Thomson Reuters. That might be the case if your income will be higher then.

Or you might believe that tax rates will be higher in the future. Paying tax now at 28% and even 33% might avoid future withdrawals at, say, 38% or 48%.

No one knows what future tax rates will be. So the normal rule of delaying taxes as long as possible might apply, especially if you don't have $60,000 lying around.

Still, it might be prudent to move part of your traditional 401(k) to a Roth account each year, over a period of years, O'Donnell says. Withdrawals from a Roth can be tax-free in the future, even if tax rates soar.

One tactic is to fill up your current tax bracket. Suppose Smith is single, with expected taxable income of $100,000 in 2013.

The 28% bracket this year goes up to $183,250 for single filers. So Smith might convert up to $83,250 of his traditional 401(k) to a Roth 401(k) in 2013. He'll have to cough up $23,310 in taxes.

Smith will stay in the 28% bracket that way. On a $40,000 conversion, for example, he'll owe an extra $11,200 in tax: 28% times $40,000. If he earns 10% a year on that $40,000, then when he's 60, he'll be able to take $433,338 from his account tax free.

Smith can do this for several years, with a relatively modest cost. Eventually, he can bring his traditional and Roth 401(k) balances into the mix he wants, between current tax deferral and future tax-free withdrawals.

Spreading a Roth conversion over several years makes it easier to pay the tax from nonretirement funds. Tapping an IRA or a company-sponsored plan for money to pay the tax generally robs a Roth conversion of its value.