401(k) Corner: Fiscal Cliff emboldens Roth 401(k)!

While directly contributing to a Roth account through a 401(k) has been available for the past few years, a silver lining in the Fiscal Cliff legislation  allows all 401(k) participants to convert their conventional 401(k) balances to Roth balances.  We could use some good news and planning techniques, too, as taxes are going up for most Americans.

For high earners, the power of tax deferral becomes more powerful due to the 25% increase on their investments’ taxation;  marginal income taxes moving from 35% to 43.4% (39.6% plus Obamacare’s 3.8% Medicare Surtax).

The silver lining is buried deep on page 152 of the Act; noted Section 902:

“Amounts in applicable retirement plans may be transferred to designated Roth accounts without distribution…the plan may allow an individual to elect to have the plan transfer any amount not otherwise distributable under the plan to a designated Roth account maintained for the benefit of the individual”.

What does this mean for you?

Previously, you were only allowed to convert your 401(k) to a Roth if you were otherwise eligible to take a distribution (i.e. over age 59.5) and the plan allowed for it. However, now you’ll be able to convert from pre-tax to after-tax dollars whenever you feel is the right once your plan has adopted the Roth feature. This opens many doors from a retirement planning perspective.

Why is Congress allowing this?

Put simply, it’s a way for them to bring future tax revenues forward to pay for today’s debts. When you convert your 401(k) to a Roth, you pay taxes today on the converted amount rather than paying taxes in the future.

Great, let’s get started!

No so fast. The language passed Congress and was signed by the President; however, it will take time for the U.S. Treasury to issue guidance on the blocking and tackling before this becomes a reality for the rest of us. As well, your plan will likely need amended to allow for the new. If you are a Plan Administrator, it would be wise to contact your advisors to understand how you can prepare…employees will likely request Roth 401(k) as part of your overall benefit structure.

Lastly, consult your tax advisor and financial planner before converting your 401(k) to a Roth. While the notion of “not paying taxes ever again” on your Roth 401(k) sounds appealing, it’s prudent to put pen to paper to see if the math works to your benefit.