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Fiscal Cliff Deal Opens Floodgates for 2013 Roth Conversions

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Many of your clients have already begun to experience the burden of higher taxes in 2013—whether in the form of higher taxes on investments or that extra 2% that has been tacked back onto their payroll taxes. Despite this, Congress’s fiscal cliff agreement provides a window that could allow many clients to reduce their future tax liability during retirement.

Hidden in the fine print of the legislation is a provision that allows clients to convert funds in their 401(k) accounts into Roth 401(k) accounts without many of the limitations that were formerly imposed on these conversions.

Converting a 401(k) to a Roth in 2013

The American Taxpayer Relief Act of 2012 (the Act) allows 401(k) plan participants to convert funds held in their traditional 401(k)s into Roth 401(k)s. Like an IRA-to-Roth-IRA conversion, this move allows 401(k) account owners to pay the taxes on the funds when they are rolled over into the Roth—so that the funds can then grow tax-free within the Roth, where they can be withdrawn without tax liability in the future. The Act does not impose any limits on the amount that can be transferred from the 401(k) to the Roth.

These types of rollovers were always permitted, but, under prior law, a 401(k) account owner was permitted to convert only the funds that he could otherwise withdraw without penalty. This limitation effectively confined conversions to those clients who had already reached age 59 ½, or who had died, become disabled, or separated from service. Other clients were required to pay a 10% penalty if they converted where distributions were not otherwise permitted.

Why Convert?

Even though we no longer have fiscal cliff tax uncertainty hanging over our heads, the permanence of the income tax rates set by the Act does not mean that your clients will be taxed at the same rates when they eventually retire. Inflation adjustments and government budgetary needs will almost certainly mean that tax rates will be higher for many of your clients when they retire, whether that is in five years or 20.

The primary benefit of converting to the Roth 401(k) is that clients choosing this path can stop wondering what tax rates will be like when they retire. The taxes are paid up front so that the funds are allowed to grow tax-free. For younger clients, this can represent decades of tax-free growth that can be drawn upon during retirement.

Who Should Convert?

Perhaps the most important consideration in determining whether a conversion is appropriate is whether the client is able to pay the current tax liability. Any amount converted must be recognized as a distribution under the Act, which means that the taxes are due as though the client had actually received the funds. The primary downside of converting a large chunk of 401(k) money this year is that, for many high-income taxpayers, ordinary income taxes have been raised for 2013. If the conversion would cause the client to cross the $400,000/$450,000 income threshold for higher income, capital gains and dividend taxes in 2013, converting may not be worth the cost. Clients who fall into higher income tax brackets and still want to convert should consider converting small amounts each year to avoid the tax hike.

More on this topic

Conversions could be highly beneficial for younger savers. These clients may not have reached their full earning potential and may fall into a lower tax bracket today than they expect to reach later in life. Further, these taxpayers have a longer period before retirement, meaning that the funds converted will have more time to grow tax-free within the Roth.


For clients who want to reduce their tax liability during retirement, the expanded conversion rules can provide significant opportunity—so long as they are willing and able to pay the taxes up front.


For more on this issue, read Big Boost to 401(k) Roth Conversions in Fiscal Cliff Deal on AdvisorOne.


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