MONEY

New 401(k) Tax Break Is Just around the Corner

People with 401(k) plans got a nice tax break last month, but they’ll have to wait for some red tape to be cleared out of the way before they can actually take advantage of it.

Thanks to a provision in the Small Business Jobs Act, which President Obama signed into law last month, 401(k) plan participants will be permitted to roll their accounts over into Roth 401(k)s. The change will give many people with defined-contribution plans greater flexibility in paying taxes; while holders of conventional 401(k)s deposit pre-tax dollars into their accounts and pay taxes upon withdrawal, Roth 401(k) holders fund their accounts with after-tax dollars but withdraw the money tax-free. (In both cases, any investment growth within the account comes free of taxes you don’t have to pay taxes as your investments grow within your account.)

The new option is similar to that already enjoyed by conventional IRA owners, who have leeway to convert those accounts into Roth IRAs. And the tradeoffs are the same, too: As with conversions of traditional IRAs to Roth IRAs, 401(k) holders converting to a Roth 401(k) will pay taxes upfront on the amount of money they convert.

Thus, the Roth option is best for people who expect to eventually jump into a higher tax bracket (or just want to hedge against the possibility that income tax rates will rise), since account-holders who roll over now won’t have to pay taxes on money they withdraw later.

It would be great to be able to make the rollover this year, but recent public comments by a Treasury official suggest that if it happens, there will be a last-minute crunch in December. Speaking at a convention of pension professionals, associate benefits tax counsel William Bortz indicated that the government was hurrying to give guidance on how to implement the new law, but that plan sponsors should wait for the guidance to come out before allowing the rollovers.

That’s not the only catch. Among the conditions that have to be met for you to enjoy this new rollover option, your employer’s retirement savings plan must offer a Roth 401(k). Nearly a third of employers currently offer plans with Roth 401(k)s and a quarter more are likely to add the feature, according to Hewitt Associates.

Other restrictions within your plan may prevent you from rolling over portions of your 401(k) before certain age or time limits, but the new law may encourage employers to make distribution rules more flexible, since employees who want a Roth option might then be less likely to pull funds out of their 401(k).

If you are interested in a conversion, you’ll need to talk to your employer about whether your plan will allow for the 401(k) to Roth 401(k) rollover and — if so — what additional restrictions might apply, says tax and elder law expert Richard Kaplan, a professor at the University of Illinois.

The new rule, built into the Small Business Jobs Act of 2010, was an unexpected provision included, in part, to generate short-term tax revenue to offset the costs of other tax breaks in the bill, says Kaplan. “The result is that it’s caught many people by surprise,” he says, “including plan administrators.”

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