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Guidance is needed on new Roth 401(k) conversion

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Although not well thought out, the Roth 401(k) conversion provision in the American Taxpayer Relief Act of 2012 could be a great opportunity for some investors moving forward.

Since provision 902 of the bill was a last-minute decision, the U.S. Department of the Treasury and Internal Revenue Service must issue some guidance, said Bob Kaplan, vice president and national training consultant at ING Investment and a member of the government affairs committee for the American Society of Pension Professionals & Actuaries, in a webinar this week.

The provision’s main purpose was to raise about $12.2 billion over the next 10 years, Kaplan said. The belief was that, if given the chance, many people would convert large portions of their 401(k) plans to Roth 401(k) plans to better manage their taxes in retirement.

“We’re not so sure. There are a lot of details that have to be worked out,” Kaplan said.

The Roth was first allowed as a deferral provision in certain types of 401(k) and 403(b) plans back in 2006. In 2010, investors were allowed to convert pretax money for portions of their accounts that were available for distribution, for instance if they had rollover money or had reached age 59½, Kaplan said.

The change under this new law allows investors to convert any portion of their pretax account to a Roth. One confusing point that Kaplan hopes will be clarified by Treasury and the IRS is whether those funds have to be vested or not. “Why in my right mind, why would I want to convert my non-vested dollars? We are waiting for Treasury to do a clarification. Probably it will come out in an FAQ or regulation. They need to give us guidance. We expect it to say vested pre-tax accounts,” he said.

It is important to note that the Roth conversion is only available to plan participants if their employer and plan sponsor add it to their plan. If they don’t add it, participants are out of luck and won’t be able to do it, he said.

Conversion to a Roth is a taxable event. Another point that needs guidance is whether an investor can pay for those taxes out of its converted dollars or if it needs to find another pot of money to do it from, he said. Treasury and the IRS need to make a decision on this soon because any conversion made this year is taxable in 2013.

The Roth conversion can only be added to retirement plans that already offer a Roth type deferral, which means 401(k), 403(b) and 457(b) plans.

“We can’t add a Roth conversion to any other type of plan, like a defined benefit, cash balance or profit-sharing type of plan with no 401(k) feature,” he said.

That said, if a plan doesn’t offer a Roth deferral, it can amend its plan to allow for Roth deferrals as well, making it a candidate for Roth conversions. Companies that decide to do this can begin offering the deferral plan immediately, but they need to make sure they amend their plan by the last day of the plan year, Kaplan said.

These plan provisions must be communicated across the board to all plan participants on a non-discriminatory basis. It can’t just be offered to people who make six figures because those are the people who will take advantage of it, he said.

It isn’t just wealthy people who are interested in Roth plans. Younger people are starting to defer with Roth because they feel their tax burden won’t be as high as later on in their life.

If a plan does have a Roth deferral feature, advisors should have a conversation with clients about tax diversification, Kaplan said. With the possibility of taxes being raised, it doesn’t hurt to discuss the best options out there.

One benefit of a Roth conversion is that investors can pay taxes now and pass that money on to their heirs tax-free.  

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