Friday, May 20, 2011

Q&A Series: Roth Conversions

We received follow-up questions to our Q&A post regarding Roth 401(k)s from Lou, a Rollins Financial client.

Q: I’m 54-years old and my employer offers the Roth option under our 401(k) plan. I currently make traditional 401(k) contributions, but after reading your Q&A post about Roth 401(k) plans, I’m wondering if converting would be a wise decision for me. Also, can you expound upon the tax considerations concerning Roth conversions?

Thanks for your questions, Lou. With more employers offering Roth 401(k) plans, we receive questions likes yours quite frequently. It’s good that you’re doing your research before going forward with an in-plan conversion, however, because this option is not always the best course for individuals. I’ll explain why below.

The Basics

As I stated in my answer to Monica’s question, Roth 401(k) plans are a combination of Roth IRA and traditional 401(k) plans. Contributions to Roth 401(k)s are not tax deductible (which means less take-home pay), but withdrawals after age 59½ are penalty- and tax-free. In traditional 401(k) plans, contributions are tax deductible, and taxes are only paid upon withdrawal after age 59½.

Interestingly, before the Small Business Jobs Act of 2010 (SBJA) was enacted in September of 2010, you could only convert traditional 401(k), 403(b) and 457(b) plans to a Roth-type retirement plan by taking a distribution and rolling it into a Roth IRA outside the plan. This was a headache for plan sponsors since distributions could only be made to the extent permitted under the plan document. Furthermore, if the plan documents expanded the distribution options to increase the amounts that could be rolled over, participants could use distributions for purposes other than Roth conversions, defeating the purpose of a retirement plan.

The SBJA, however, solved this problem by allowing conversions of amounts held in traditional 401(k), 403(b) and 457(b) plans to designated Roth accounts in the same plan. The law also allowed for plan amendments insofar as creating a new distribution option solely for in-plan Roth conversions (IPRCs). The caveat? Generally, IPRCs are only available to participants who are age 59½ or older, are disabled, or who have died. “Qualified reservist distributions” for participants who are called to active duty in the Armed Forces are also eligible for IPRCs. Thus, an employer must amend its non-Roth plan to provide a Roth contribution option as wells as to allow in-service, non-hardship distributions to specifically allow current employees not meeting the eligibility requirements to do an IPRC. If your plan allows for in-service conversions, then you are free to do an IPRC as you deem appropriate.

The SBJA also relaxed the rules concerning converting from a traditional IRA to a Roth IRA. Prior to the SBJA, only taxpayers with a modified adjusted gross income of $100,000 or less in the year of conversion – and who were not married filing separately – could convert from a traditional to a Roth IRA. Beginning in 2011, however, all taxpayers – even those with a modified AGI of $100,000 or more – have the option to convert to Roth IRAs from traditional IRAs. Again, the consideration is whether it’s better for you to make a tax deductible traditional IRA contribution and pay taxes on the distributions from the account at retirement or pay the taxes (and cost of the conversion) up-front and have tax-free withdrawals once you retire with a Roth IRA.

Evaluating the Options

As I explained to Monica, most young people can expect for their tax rate in retirement to be the same or higher than it is now. As such, they are typically better off paying the taxes now (i.e., less take home pay) by contributing to a Roth 401(k) or Roth IRA and allowing the assets to grow for 30 to 40 years. On the other hand, individuals in their peak earning years who will likely be in a lower tax bracket in retirement will likely benefit from traditional 401(k)/IRA contributions. Simply put, it may not make sense to pay taxes today at a higher rate if it’s likely you’ll be in a lower tax bracket when you retire.

When it comes to Roth conversions, it’s important to note that you must report and pay taxes on the amount you convert on your individual income tax return for the year of the conversion. For example, someone with $100,000 in a traditional 401(k) or IRA who’s in the 28% federal tax bracket would pay $28,000 in taxes – plus whatever may be owed in state taxes – during the year of conversion. Also, if you don’t pay the taxes using outside funds and instead have withholding taken on the conversion amount, you will be subject to the 10% early withdrawal penalty on the amount withheld since that amount is not part of the rollover. In short, it may not be practical to do a Roth conversion, unless you expect to be taxed at a higher rate at retirement. And, as you can see, it's rarely wise to use your retirement assets to pay the taxes on the conversion.

If you’re not sure what your future tax rate may be – or if you have a large traditional portfolio that would require a substantial tax payment at conversion – you might want to consider a partial conversion to a Roth. The diversification benefits from having some money in a Roth and some in a traditional retirement account may make this the most tax-efficient plan for you.

Keep in mind that Roth accounts, including those converted from traditional retirement accounts, must be held for at least five years – and participants must be at least age 59½ – before tax-free withdrawals can be taken. If you don’t meet the exemptions under those rules, you’ll face a 10% penalty on distributions taken before the five-year holding period or if you are younger than 59½ and take a distribution.

So, what happens if you do a Roth IRA conversion only to regret the decision soon after? Don’t fret; a Roth can be recharacterized (switched back) to a traditional IRA or qualified plan. The taxpayer would have until the following April 15th to reverse the transfer (October 15th if an extension was timely filed). However – and this is important – IPRCs cannot be recharacterized.

If you qualify for taking an IPRC from your 401(k) plan under the standard eligibility requirements outlined above, you now have two choices: you can either roll traditional amounts into a Roth IRA or roll them into an in-plan Roth account (plan documents permitting). Again, in-service employees can only do IPRCs. But depending on your individual circumstances, converting outside the plan may be better. Here are some additional items to consider:
  • If you won’t be relying on the assets to provide income during your retirement and are more interested in accumulating wealth to pass on to your heirs, then converting to a Roth IRA is much more favorable. This is because qualified plans – including Roth 401(k)s – require participants to take required minimum distributions (RMDs), after age 70½, but Roth IRAs do not.
  • The recharacterization provision available to Roth IRAs – but not to IPRCs – is a significant advantage. If you do an IPRC and change your mind shortly thereafter, you can’t switch back to the traditional account.
  • IPRCs are advantageous to individuals who are in professions with high liability risks (e.g., doctors and lawyers). This is because in-plan assets are offered greater protection than assets in a Roth IRA.
Based on the foregoing, for most individuals qualifying under the standard eligibility requirements, it’s better to convert outside the plan rather than inside when offered the choice.

Thanks so much for your question, Lou. As in all tax and financial matters, it’s important to fully evaluate your particular situation when deciding whether or not to do a Roth conversion. This post just touches on Roth conversion basics and scenarios. It’s a complex subject, and I suggest consulting with a professional for a more specific and thorough evaluation of your requirements.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

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