Roth Conversions For Everyone

The recent “fiscal cliff” legislation, the American Taxpayer Relief Act 2012 includes a revenue raising idea for the government – more Roth conversions. The new provision would allow private company defined contribution plans (i.e., 401(k) and profit sharing plans); Section 403(b) plans for tax exempts and governmental 457(b) plans to allow plan participants to convert any vested pre-tax amounts held within those plans into Roth amounts. The only requirement is that the plan include (or is amended to) provide for Roth contributions other than rollovers.

Why would participants consider Roth conversions? Converted amounts are subject to federal and state income taxes in the year converted but the 10% early withdrawal tax is waived. Converted amounts are not subject to withholding and financial planners (and interestingly, the IRS), advise taxpayers to pay the taxes owed on Roth conversions from other earned income withholding or after tax savings if possible. After the five year Roth holding period, earnings on Roth accounts is income tax free. Under the legislation, Roth conversions are also available to surviving spouse beneficiaries and alternate payees under qualified domestic relations order, but not to other beneficiaries.

The newly expanded Roth conversions are irrevocable and cannot be re-characterized in the same manner as Roth IRA conversions. Congress projects this new provision will raise over $12 billion over the next ten years.