Roth 401(k) Plans Get a Big Boost in the New Tax Law

The new tax law that resolved the “fiscal cliff” issue in January allows employees with a 401(k) plan at work to roll over any or all of the assets in their current plan into a Roth 401(k) plan. This is a big change, and should at least be considered by anyone who is eligible.

In a traditional IRA or 401(k) plan, employees contribute pre-tax earnings to the plan. The assets grow tax-free until retirement age, at which point the employee can withdraw them and pay ordinary income tax on the withdrawals.

With a Roth IRA, though, employees contribute post-tax earnings to the account, but when they withdraw the assets years later, the withdrawals are tax-free.

The new Roth 401(k) plans follow the same idea – earnings are contributed post-tax, but withdrawals are tax-free.

Roth 401(k) plans were first allowed by Congress in 2006, but they were more limited, and rollovers of current 401(k) assets were severely restricted. At the time, not many employers bothered to create Roth 401(k) plans. But with the new law, it’s likely that many more employers will begin to offer Roth 401(k)s as a result of employee demand.

The law also allows rollovers to Roth 403(b) plans, Roth 457(b) plans, and Roth thrift saving plans.

The trick with a Roth rollover – whether from a traditional IRA or a traditional 401(k) or other plan – is that you have to pay income tax in the year of the rollover on the amount of assets you transfer.
Having to pay the income tax now is a drawback, of course, but if you have the assets to do so, a rollover can be very smart. For instance, if you anticipate being in a higher tax bracket when you retire, or if you believe that tax rates in general will go up, then you might want to pay the income tax now at today’s lower rates.

Also, if you plan to eventually convert your 401(k) to an IRA and leave it to your heirs, then a rollover might make sense because you’ll get the amount of the income tax out of your estate for estate tax purposes, and you’ll leave your heirs a better benefit because their withdrawals will be tax-free.

Keep in mind that rollovers are not “all or nothing.” You can roll over only a part of your 401(k) account each year, and pay taxes on just that amount.

Another benefit of Roth 401(k)s is that the contribution limits are generally much higher than for Roth IRAs.

You should note that if you roll over a traditional 401(k) into a Roth 401(k), you can’t “undo” the conversion the following year, as you can when you roll a traditional IRA into a Roth IRA. (The ability to undo the conversion is a benefit, because if the assets in your IRA incur significant losses after the conversion, you can simply undo it and then redo it the next year while paying less in taxes.)