Uncle Sam's plan to raise more revenue opens up a retirement savings opportunity for some workers.
A provision tucked into the American Taxpayer Relief Act of 2012, which President Barack Obama signed into law early this month, allows more employees to convert funds from a traditional 401(k) to a Roth 401(k).
Before, employees could transfer money from a traditional 401(k) to a Roth 401(k) only if certain conditions were met.
Now the only conditions to be eligible are that your employer must offer a Roth 401(k) and offer the option to convert.
Currently, about 40 percent of midsize and large employers have the Roth 401(k), said Alison Borland, vice president of retirement solutions and strategies at consulting firm Aon Hewitt.
A Roth 401(k) is an employer-sponsored retirement savings account that's funded with after-tax money, meaning you pay the tax now on the money you put aside. After you reach age 59 1/2, withdrawals of any money from the account — including investment gains — are tax-free.
In contrast, a regular 401(k) is funded with pretax money, and you pay the tax when you make withdrawals.
So when you convert a traditional 401(k) to a Roth 401(k), you pay tax now on the amount in the account, just as you would if you converted a traditional IRA into a Roth IRA.
It's changing the tax treatment of their account from paying later to paying now, Borland said.
Given the benefits of Roth plans, I wouldn't be surprised if more employees took advantage of a Roth 401(k).
For one, the Roth 401(k) has no income limitations for those who want to participate, unlike a Roth IRA. Anyone, no matter what income level, is allowed to invest up to the contribution limit into the plan.
But give it lots of thought before deciding to convert your plan.
The decision to convert is highly complicated and depends on your time horizon for distributions, and your guess as to future tax rates and rates of growth and inflation, said Ronnie C. McClure, a certified public accountant in Lewisville, Texas.
Experts say a Roth 401(k) is best suited for those who think they will be in a higher tax bracket in retirement than they are now.
It's good for some people, Borland said. The reason you'd want to pay tax now instead of paying it later is if you think you'd pay less tax now. If you think you're going to be in a lower tax bracket today than you are when you retire, a Roth might be a really good idea for you.
On the other hand, if you're already in a very high earnings place with a high tax rate and you expect that will go down when you retire, then a Roth would not be a good option for you, she said.
Consult a tax adviser before you decide whether to convert to a Roth 401(k).
We encourage participants to evaluate their tax strategy when considering a Roth conversion, and recommend that participants have funds outside of their 401(k) savings to cover the tax liability associated with the conversion, said Donna Norwood, senior vice president at Fidelity Investments. Furthermore, a participant must be cognizant of whether the income related to the conversion may push them into the higher tax rates as set forth in the new law.
The Roth 401(k) provision may encourage more companies to offer such an account.
First, it may encourage plan sponsors who have not done so to implement a Roth feature in their plan, Norwood said. Second, it permits participants in authorizing plans to diversify savings amounts in their accounts that are invested on both a pretax and post-tax basis, and we feel this type of investment diversification may be just as important as diversifying across asset classes.
No matter what you decide to do — with the help of your tax adviser — this is too good an opportunity not to explore.
Pamela Yip is a personal finance columnist for the Dallas Morning News. Readers may send her email at pyipdallasnews.com; she cannot make individual replies.