Back in 2006 the government passed a law that took effect in 2010 lifting income restrictions on converting individual retirement accounts (IRAs). Now, there’s no limit on conversions nor a cap on the amount that can be shifted.
The budget deal that passed Congress on January 1st allows 401(k) participants to convert any money in their tax-deferred accounts to a Roth 401(k) account, provided the option is available in their plan, of course. This would allow the participants to withdraw money tax-free in retirement. The old law allowed participants to convert part of their money, with a number of restrictions. Basically, this new law is allowing participants to convert any money in their plan and it may encourage more employers to offer Roth 401(k) accounts.
According to the Joint Committee on Taxation, this change could raise as much as $12.2 billion in revenue over 10 years, helping to defray the cost of delaying spending cuts that had been set to take effect this month.
For some, this change could benefit those who have significant balances in their 401(k) accounts, the money to pay taxes from assets outside their 401(k) assets, and who have years of tax-free earnings ahead of them or their heirs.
Wealthy investors who want to leave their retirement accounts to heirs and younger savers are the ones who may benefit most… it allows them to pay taxes now for their kids!
Younger investors – the ones who’s 401(k) constitutes a small part of their net worth – may want to consider converting a portion or all of their 401(k)s now since they have more time in the future to recoup the initial tax outlay and to grow their money virtually tax-free.
Don’t plan on running out and doing this right away. Companies offering these plans are going to be looking for guidance from the Treasury Department before making amendments to their plans and, according to Bloomberg, only about 12% of plan sponsors offer and allow conversions to Roth 401(k) accounts.
Points woth remembering
The old law allowed taxpayers to choose whether to pay the tax all at once or split it over two years when converting. The new law has no such option.
When you do a conversion, you have to pay a tax. It’s best if you can pay them from assets outside your 401(k) plan in order to maintain the asset level in your retirement account.
Those at or near retirement with a 401(k) balance that constitutes a large portion of net worth needed for retirement years probably shouldn’t make a conversion..
Look out for “legislative risk” – Tax laws seem to change frequently; and while some feel the government will lower taxes in the future, others believe the ‘middle class’ will not be able to escape higher taxes as our national debt continues to increase. Diversification of legislative risk could be accomplished by partial conversions. Thinking about where you will retire is important, too. You may want to consider retiring to a state with no state income taxes – I have quite a few clients who’ve done just that!
Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and an ACCREDITED INVESTMENT FIDUCIARY® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors, and retirement and wealth management services for individual investors.
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