The Senate's decision to lift restrictions on Roth 401(k) conversions will be a boon to select individuals — those who can afford the tax bill now and whose employers have a Roth plan in place.
A key to the American Taxpayer Relief Act of 2012, buried at the end of the 157-page law that President Barack Obama signed last Wednesday, relaxes restrictions that have kept workers from rolling over traditional 401(k) accounts to Roth 401(k)s.
The idea was that taxes paid by Roth converters would at least help address the looming budget shortfalls.
Until now, to make such a distribution without incurring a 10% penalty, workers must either have been retiring, terminating their job with their employer or turning 591/2. But under the new law, employees can move their traditional 401(k) to a Roth version of the account without those events and without the penalty.
Because Roth 401(k)s are taxed when they are set up — not when funds are distributed, as in traditional plans — the government will reap the revenue benefit of conversions. Lawmakers expect to collect $12 billion in taxes over the next 10 years from plan participants making Roth 401(k) conversions.
However, advisers noted that Congress' decision is a win only for a narrow group of individuals: younger workers who are building their 401(k) accounts and who can afford the upfront tax bite of the conversion.
“Say you're 40, and you have $100,000 in a 401(k) and you want to convert to avoid higher taxes, you can do it,” said Ed Slott, creator of The IRA Leadership Program. “But for older employees, it's not as [good] a deal.”
For older investors — a large chunk of advisers' clientele — the upfront tax bite usually outweighs the advantage of having tax-free income in retirement.
BIGGEST FACTORIn the ideal situation, a client is earning less now than he or she will be in the future. In this case, the tax paid today on the conversion would be at the lowest rate possible.
That makes higher-income clients, especially pre-retirees, the least eligible candidates for the deal, according to Michael Kitces, a partner at Pinnacle Advisory Group Inc.
“If your income hasn't risen much yet, then it's a good idea to convert to Roth status,” he said. “But if your income is higher now and you think it'll be lower in the future, then stick with the traditional 401(k).”
Aside from the income and age questions, the availability of a conversion to a Roth account from a 401(k), 403(b) or 457 retirement plan is the biggest factor that will determine its usefulness to advisers' clients. The law paves the way for an in-plan conversion, and companies have been adding Roth accounts.
A 2011 Aon Hewitt survey of 546 midsize to large plans found that 40% offered a Roth contribution capability that year. In 2009, 33% of plans offered Roth accounts, while 11% did so in 2007. The company takes the survey every other year.
Although the law could prompt more plan sponsors to add Roth accounts, getting them up and going is no easy feat.
“It's a decision that needs to be communicated to the worker in a way that they understand,” said Alison Borland, vice president of retirement solutions and strategies at Aon Hewitt. “And there is more complexity.”
Further, employees already struggle with decisions about handling their retirement savings, so adding the choice to convert to a Roth will only give them another thing to worry about, Ms. Borland said. Plan sponsors would have to find a way to educate participants about the option and encourage them to think about whether their own individual financial situation were ideal for a conversion, she added.
“There are a lot of different things to think about, and they'll be dependent on your own circumstances,” Ms. Borland said.
“Employers feel comfortable saying that everyone needs to save more, but you don't want to say that everyone should do a Roth,” she said. “It may not be the right time, and it may not be right at all.”
Another reason why advisers might think twice about having clients jump on the Roth 401(k) bandwagon is that the conversions are irreversible.
“With a Roth IRA, you have the option of undoing a conversion until Oct. 15 of the following year,” Mr. Slott said.
“With the Roth 401(k), there is no second look,” he said. “It's a done deal.”
Still, employees who can take advantage of the deal would be getting a jump-start on their retirement planning. They would have the benefit of tax diversification, as the Roth would give them tax-free income later, and advisers could help create a tax-efficient drawdown strategy once these workers retired.
“The average participant won't convert their entire 401(k) balance to a Roth,” said Brian Douglas, a retirement sales consultant at Commonwealth Financial Network. “Advisers want tax diversification; you can customize your withdrawal strategy based on your circumstances.”
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