As the curtain came down on 2012, most investors assumed that with it went the best opportunity for Roth conversions. The general expectation was that higher tax rates this year would make Roth conversions less attractive for a broad swath of clients, which led many to try to complete conversions under 2012's lower rates.
But Congress surprised us.
First, Roth conversions were left in play for more people because income tax hikes were limited to a very narrow group. Second, in an effort to generate tax revenue, Congress made it easier for active retirement plan participants to complete an intraplan conversion to a Roth 401(k) or comparable employer-sponsored Roth plan if that option is available to them.
The new rules for intraplan Roth conversions are more liberal than the previous rules. Prior to this year, a Roth conversion could occur only when an event such as separation of service, death, disability or attainment of age 591/2 (if the plan allowed for in-service distributions) occurred.
Now, if the plan sponsor chooses to allow it, an intraplan Roth conversion can be done without meeting any of these criteria.
Note that the rules for distribution to a Roth IRA are unchanged and continue to require a triggering event.
WHEN TO CONVERT
Although more plan participants are candidates for Roth 401(k) conversions, the question of whether converting is appropriate is the same. Most or all of these conditions should apply before choosing to do a Roth 401(k) conversion:
• The client expects to be in a comparable or higher tax bracket during retirement.
• Money is available to pay the tax liability without depleting retirement savings.
• The client would benefit from greater tax diversification by building up tax-free investments.
• There is a desire to pass benefits to heirs in a more tax-advantaged way.
If clients determine that a conversion is worth considering, another factor to bear in mind is whether it is best to execute it now with an intraplan conversion or wait until they can qualify for a Roth IRA conversion. If clients participate in a workplace plan that allows in-service distributions, the window to do a Roth IRA conversion may be available sooner than if their plan doesn't have in-service provisions.
Some investors may prefer to convert to a Roth 401(k) because they are already familiar with the investment options in the plan. But there are some considerations to keep in mind:
• A “do-over” via re-characterization isn't allowed with a Roth 401(k) conversion. By contrast, individuals always have the flexibility to re-characterize a Roth IRA conversion up to Oct. 15 of the following year.
• Nonqualified distributions from a Roth 401(k) are treated on a pro-rata basis, meaning that each distribution is treated as a mix of contributions, already taxed converted amounts and untaxed earnings. Roth IRAs have an advantage, as distributions are treated in the following order: contributions, converted dollars and earnings.
Of course, this isn't a concern if the individual has met qualifying requirements for fully tax-free withdrawals from the Roth account.
• Roth IRAs aren't subject to required-minimum-distribution rules. Distributions are required from Roth 401(k)s at 701/2, so clients can't preserve all or a large portion of this tax-advantaged account throughout their lives. However, they ultimately will have the ability to move Roth 401(k) assets to a Roth IRA in order to gain this advantage.
Remember that when a nonqualified distribution from a Roth 401(k) is moved to a new Roth IRA, the five-year waiting period to gain tax-free access to earnings will start over again. However, if Roth 401(k) assets are rolled into an existing Roth IRA, the five-year clock that had already started for the Roth IRA applies to Roth 401(k) assets, as well.
Other prospects for intraplan or Roth IRA conversions are clients who make after-tax contributions to their retirement plan. Because contributions make up the bulk of the converted amount, there is little current tax liability.
We know that the tax change discussion probably isn't over in Washington, and some of the rules surrounding Roth conversions may change yet again as Congress begins — and hopefully concludes — the debt ceiling discussion. Regardless, the anticipation of change is one more reason to ask clients about their expanding Roth conversion options.
Craig Brimhall is vice president of retirement wealth strategies at Ameriprise Financial Inc.