U.S. workers willing to take tax pain today in exchange for tax-free gains on earnings in their 401(k) retirement accounts later have a new avenue to do so.
The budget legislation passed by Congress Jan. 1 lets 401(k) participants convert any money in their tax-deferred accounts to a so-called Roth 401(k) account, if their employer offers one, which can be withdrawn tax-free in retirement. The change is projected to raise $12.2 billion in revenue over 10 years, according to the Joint Committee on Taxation, and help defray the cost of delaying spending cuts that had been set to take effect this month.
“This dramatically expands the number of participants who can use this provision,” said Bob Holcomb, executive director of legislative and regulatory affairs for JPMorgan Chase & Co.’s retirement plan services. “It will allow any amount to be transferred.”
The conversion opportunity can benefit people with significant balances, the up-front money to pay taxes now with funds outside their retirement account and years of tax-free earnings ahead of them or their heirs. Conversions to Roth 401(k)s had been limited to certain funds and to plans that allowed the switches. The law opens the opportunity to more workers who hold $5 trillion in employer-sponsored defined contribution plans including 401(k)s.
Deferring Taxes
Contributions to a traditional 401(k) account are tax- deferred, with taxes paid at ordinary income rates when the money is withdrawn in retirement. When savers put money into a Roth 401(k) account, they pay taxes on the money upfront in exchange for tax-free withdrawals later.
The new conversion opportunity may help wealthy investors who want to leave their retirement accounts to heirs and younger savers, said John Olivieri, a partner in the private clients group at New York-based law firm White & Case LLP.
“This is really a huge benefit to heirs,” Olivieri said. “Basically you can pay tax now for your kids.”
Younger investors may wish to convert a portion or all of their account if it’s a small part of their net worth because they have more time to make back the money they lose in paying the tax upfront, Olivieri said.
Fund Transfers