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Budget Deal Lets More Savers Switch to Roth 401(k): Taxes

January 03, 2013

Budget Deal Lets More Savers Convert to Roth 401(k)s

The U.S. Capitol illuminates at dusk on Capitol Hill on Dec. 31, 2012 at the House and Senate are in session on New Year's Eve over the 'fiscal cliff' issue. Photographer: Drew Angerer/Getty Images

U.S. workers willing to take tax pain today in exchange for tax-free gains on earnings in their 401(k) retirement accounts later have a new avenue to do so.

The budget legislation passed by Congress Jan. 1 lets 401(k) participants convert any money in their tax-deferred accounts to a so-called Roth 401(k) account, if their employer offers one, which can be withdrawn tax-free in retirement. The change is projected to raise $12.2 billion in revenue over 10 years, according to the Joint Committee on Taxation, and help defray the cost of delaying spending cuts that had been set to take effect this month.

“This dramatically expands the number of participants who can use this provision,” said Bob Holcomb, executive director of legislative and regulatory affairs for JPMorgan Chase & Co. (JPM:US)’s retirement plan services. “It will allow any amount to be transferred.”

The conversion opportunity can benefit people with significant balances, the up-front money to pay taxes now with funds outside their retirement account and years of tax-free earnings ahead of them or their heirs. Conversions to Roth 401(k)s had been limited to certain funds and to plans that allowed the switches. The law opens the opportunity to more workers who hold $5 trillion in employer-sponsored defined contribution plans including 401(k)s.

Deferring Taxes

Contributions to a traditional 401(k) account are tax- deferred, with taxes paid at ordinary income rates when the money is withdrawn in retirement. When savers put money into a Roth 401(k) account, they pay taxes on the money upfront in exchange for tax-free withdrawals later.

The new conversion opportunity may help wealthy investors who want to leave their retirement accounts to heirs and younger savers, said John Olivieri, a partner in the private clients group at New York-based law firm White & Case LLP.

“This is really a huge benefit to heirs,” Olivieri said. “Basically you can pay tax now for your kids.”

Younger investors may wish to convert a portion or all of their account if it’s a small part of their net worth because they have more time to make back the money they lose in paying the tax upfront, Olivieri said.

Fund Transfers

A provision in a 2010 law allowed some 401(k) participants to convert part of the money in their plan to a Roth 401(k) account, with restrictions: Their employer had to offer a Roth 401(k) and allow conversions. Funds transferred were limited to money eligible for distribution, such as that held by savers age 59½ and older, and some employer contributions, said Alison Borland, vice president of retirement solutions and strategies at Lincolnshire, Illinois-based Aon Hewitt. It is a unit of Aon Plc (AON:US) that administers 401(k) plans for about 5 million workers.

“Now they are saying you can convert any money,” said Ed Ferrigno, vice president of Washington affairs for the Plan Sponsor Council of America. The Chicago-based group represents about 1,000 employers that sponsor plans and lobbied for the 2010 law change as another way for participants to diversify their savings, Ferrigno said. The budget legislation may encourage more employers to offer Roth 401(k) accounts, even as questions remain about the logistics, he said.

Plan Guidance

“This isn’t going to happen overnight,” he said. “Treasury is going to have to issue guidance. Plans are going to have to make amendments.”

The new provision is more than seven years old and was recently updated and drafted into legislative form when lawmakers went looking to fill a revenue shortfall in the bill, said a Senate aide, who spoke on condition of anonymity to discuss the idea’s development.

Americans held $5 trillion in defined contribution plans as of Sept. 30, including $3.5 trillion in 401(k)s, according to the Washington-based Investment Company Institute.

About 12 percent of plan sponsors offer and allow conversions to Roth 401(k) accounts and the majority of them don’t charge a fee for it, Borland said. Participants should ask whether there’s a cost for such a transaction, she said.

A taxpayer in the top income bracket with a 401(k) worth $1 million may pay 39.6 percent, or $396,000, in federal taxes this year when converting the entire account into a Roth 401(k). The legislation allows all or a portion of funds in an account to be converted to a Roth within the same plan, Olivieri said. Once the taxes are paid upfront, all of the additional earnings and appreciation in the account are tax-free, he said.

Tax Cut

The new opportunity gives a tax cut to the wealthy and will cost the government in the future, Robert Greenstein, founder and president of the Center on Budget and Policy Priorities wrote yesterday. The Washington-based center is a group favoring policies that benefit low-income households.

“Every dollar of that $12 billion is revenue that the federal Treasury would have collected in subsequent decades,” Greenstein wrote in a post on the center’s website.  “The resulting revenue loss in later decades will be substantially greater than $12 billion -- probably several times that amount.”

Congress has turned to Roth accounts before as a revenue raiser.

Roth IRAs

The government lifted income restrictions on converting an individual retirement account, or IRA, under a provision of a 2006 law that took effect in 2010. That’s when U.S. taxpayers making more than $100,000 a year in adjusted income could start making the transfers. There’s no limit on conversions if an investor has multiple IRAs, nor a cap on the amount that can be shifted.

When the Roth IRA conversion rules changed, Internal Revenue Service regulations allowed taxpayers to choose whether to pay all the tax in 2010, or split it between tax years 2011 and 2012. The legislation passed this week didn’t include a similar specification on payment of taxes on conversions.

Fidelity Investments, the largest 401(k) plan provider, saw more than 355,000 Roth IRA conversions from January 2010 to June 2012, according to Deborah Pont, a spokeswoman for the Boston- based mutual-fund firm.

Vanguard Group Inc. saw 244,356 in conversions of traditional IRAs to Roth IRAs to in 2010, a 91 percent increase from 2009 before the income limits were lifted, according to Linda Wolohan, a spokeswoman for the Valley Forge, Pennsylvania- based firm.

Backing Off

The scope of possible conversions may be smaller at the start for 401(k) plans because only about half of employers in 2011 offered Roth accounts in their plans and most of those didn’t allow conversions, according to Vanguard.

Fewer than 2 percent of plans administered by Vanguard have opted to allow Roth 401(k) conversions and about 500 participants have taken advantage of the move since the 2010 legislation, said Jean Young, senior research analyst at Vanguard’s Center for Retirement Research.

“The thing to keep in mind is that when people do that type of conversion they have to pay a tax,” Young said. “When they realize they have to pay the taxes they tend to back off.”

A Roth conversion works best when an investor can pay the taxes with funds outside the 401(k) so as not to deplete savings in the account, said John Sweeney, executive vice president of planning and advisory services at Fidelity.

Educate Savers

While the change is important for investors, Washington may end up disappointed with the revenue it creates if policy makers, investment managers, 401(k) plan providers and financial advisers don’t educate savers.

“Unless there is a clear communication strategy, you may not see that much change,” Fredrik Axsater, global head of defined contribution for Boston-based State Street Corp. (STT:US)’s investment management unit, State Street Global Advisors.

Investors who are near or at retirement with a 401(k) balance that is a large portion of their net worth that they need to spend in their remaining years rather than transfer to heirs shouldn’t make the conversion, Olivieri said.

“It will take a chunk of your other money and it will take you awhile to earn it back,” he said.

People also should be aware that there’s a chance, however slim, the government will lower taxes in the future. They should consider whether they plan to retire in a place without state income taxes, which would reduce their total liability, Olivieri said.

“A lot of blind faith goes into this that if you pay the tax now you don’t ever pay later,” he said.

To contact the reporters on this story: Margaret Collins in New York at mcollins45@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net


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