401(k) Roth conversions are a good long-term deal if you can afford the additional taxes now

shutterstock_1074049Under the notion that things could always get worse, some commentators state that the American Taxpayer Relief Act of 2012 (the so-called “fiscal cliff” fix) was good for affluent Americans. This is nonsense, particularly with the threat of even higher taxes under some “balanced” approach.

But, there is one aspect in which the American Taxpayer Relief Act of 2012 made it easier for the affluent. By attempting to raise money in the short-term (an estimated 12.1 billion in tax over the next 10 years), Congress and the President agreed that workers with regular 401(k) account balances could be moved into a Roth 401(k). With a regular 401(k), you pay no income tax on plan contributions into the account, and the money grows without current taxation. However, when the money is removed, every dollar you take out is taxed as ordinary income, including moneys that might otherwise get favorable dividend or capital gains taxation. In contrast, with a Roth 401(k), you pay tax on money that goes into the account, but it grows tax free and remains tax free when you remove it from the plan, as long as (i) you had the account for more than five years and (ii) you are at least 59 ½, dead, or disabled.

Stated otherwise, in a Roth conversion now allowed by the American Taxpayer Relief Act of 2012, account holders have to pay the additional taxes now, but all future appreciation in the asset balance would then be tax free. Long-term, allowing the Roth option will cost the U.S. government plenty.

Of course, the sponsoring employer needs to include a Roth option in their plan, an option that has been available since 2006. Some employers have been surprisingly slow to add this option to their plan. I say “surprisingly”, because the cost of amending the plan to include a Roth option is not great, and the benefits to workers desiring this opportunity are substantial.

Conversion of regular to Roth 401(k) balances has been allowed since 2010 under limited circumstances, under what is called an in-plan conversion. The current change makes the conversion much simpler, and more accessible under may plans.

Practically all of the articles on the use of Roth vs. regular 401(k) accounts are overly simplistic. This article provides substantial additional information for why affluent persons in particular should be electing the Roth option, including converting regular balances to Roth balances by paying additional tax now.



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