Contributions to a traditional 401(k) account are pre-tax contributions that are taxed at ordinary income rates when the money is withdrawn later in retirement. With a Roth 401(k) account, employees pay taxes on the contributed money up front, in exchange for tax-free withdrawals later in retirement.
Budget legislation passed by Congress on Jan. 1, 2013, allows 401(k) participants to convert money in their pre-tax deferral accounts to a so-called Roth 401(k) deferral account, if the plan allows for Roth after-tax accounts and also allows for the Roth conversion. A provision in an earlier 2010 law allowed similar conversions, but with certain restrictions (i.e., the employer’s plan had to offer a Roth 401(k) and allow Roth conversions, and the employee had to be entitled to a distribution, such as having already attained normal retirement age). Under the new law, employees would no longer have to be entitled to a distribution before they could convert pre-tax deferrals to Roth after-tax deferrals.
This law provides employees with an opportunity to move their retirement funds as part of retirement and tax planning strategies, but because employees who participate in this type of Roth conversion incur an upfront tax on the amounts converted, the ultimate decision of whether to take advantage of the change is a personal one - depending upon the employee’s individual circumstances and financial goals. Employers (plan sponsors) need to consider whether they want to offer this conversion benefit. If so, the employer should have plan documents reviewed and amended to allow the newly-expanded Roth conversions.