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when they are rolled over into the Roth — so that the funds can then grow tax-free within the Roth, where they can be withdrawn without tax liability in the future.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 59½, or who had died, become disabled, or separated from service. Other clients were required to pay a 10 percent penalty if they converted where distributions were not otherwise permitted.
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 twenty.
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.