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Convert Your 401k to a Roth 401K?


Did you take the time to read The American Taxpayer Relief Act of 2012?  If you are like most Americans not only did you not read it, you may not even know what it is!  The Act, better known as the Fiscal Cliff deal, was enacted on January 3, 2013.  And although it may be best known for locking in some of the Bush era tax cuts, it also gave new benefits to employees who participated in their employer’s retirement plan, in that it allows for an expanded use of a Roth conversion.

Just so everyone is on the same page, when I say “traditional retirement assets” I am talking about your regular old traditional IRA, 401(k), 403(b), Simple, SEP, 457.  In those plans you contribute PRE tax money, which then grows tax deferred and IS TAXED when you withdraw to enjoy your retirement.  A Roth IRA, 401(k), 403(b) or 457 is the opposite.  Your AFTER tax money is invested and grows tax free, and when you withdraw, your withdrawals ARE NOT TAXED. So essentially, it is pay taxes later for the traditional or pay taxes now for the Roth.

Prior to this Act you had two options to convert traditional retirement assets to a Roth account.  The first was to convert a traditional IRA to a Roth IRA. Otherwise if you had assets in an employer’s retirement plan such as a 401(k), 457 or 403(b) these funds had to be eligible for distribution before they could be converted.  Being eligible for distribution would include being age 59 1/2 , having left your employer, or being disabled, among other factors.  For the majority of employees conversion was not an option.

What this opens up for the millions who have funds in their employer’s retirement plan and who are not eligible to distribute those assets do what the rest could do.  This is particularly attractive for those who are thinking that their tax bracket or taxes in general, will be higher later in life than they are now. Others may just want to hedge their bets on what is coming and have some assets in traditional retirement accounts and some in Roth accounts.  For the U.S. Government it offers a way to generate new revenue right now when they need it most, without having to raise taxes

No there is still no free lunch.  When you convert something that you have not yet paid tax on to something where you pay tax on it up front, a tax bill comes due.   Assuming you haven’t made any non-deductible contributions the value of what you convert on the day you convert it will be treated as income.  This will need to be recorded on your 1040 when you next file your taxes.  Also your plan must have a Roth option, many still don’t, and accept conversions.  You will want to check with your employer to make sure it has both.

Because of the tax implications of doing a conversion it is important to tax with your Financial Advisor and Tax Advisor before implementing to understand exactly how this will affect you.

 

 

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Comment   |  6 years, 7 months ago from Palatine, IL