Saturday, November 6, 2010

Problems with Converting to a Company-Sponsored Roth

Are you still considering converting pre-tax retirement money to a Roth? I wrote about this back in July. There’s another incentive Congress has given to get taxpayers to convert and thereby boost tax revenues … The Small Business Jobs Act of 2010 includes a provision that allows certain 401(k) and 403(b) participants to convert their plan funds to a Roth 401(k) or Roth 403(b) within the plan. Money you convert in 2010 will be eligible for the same tax option as IRA conversions made to a Roth IRA. That means you can split the tax liability over 2011 and 2012. And once you convert you or your beneficiaries will never owe income tax on that money, or the earnings! All of this sounds pretty good. After all the way I see it, taxes are almost guaranteed to go up in the future. So if you can get the tax bill out of the way today while rates are relatively low, you’ll have more to spend when you retire. Plus if you can do it with money that’s in your company-sponsored retirement plan, it looks like a good deal. Right? Well … there could be problem. You see, there are three obstacles you must overcome to take advantage of the tax provision. And even if you get around them, you might find you’d be better off moving the money outside your employer’s plan. Obstacle #1 Your 401(k) or 403(b) has to offer a Roth option. Unfortunately, not many do. Obstacle #2 Does your company’s plan allow in-plan Roth conversions? Your company might be reluctant to take on the additional recordkeeping that’s required. Obstacle #3 Are you eligible to take a distribution from the plan? You just can’t move money from a pre-tax plan to a company-sponsored Roth without taking a distribution. And for most plans the only time you can take a distribution is after you leave the company. So you need to see if you can access your funds while you’re still working. If find, though, that one or more of the above obstacles prevents you from converting a 401(k) to an in-house Roth, all is not lost … You can still transfer money from the company plan to your IRA. Once it’s in your IRA, you simply convert it to a Roth IRA and pay the income taxes as discussed above. And like a company-sponsored Roth, you’ll never have to worry about paying income taxes on that money again. After all is said and done, which is better: A Roth option within your 401(k) or a Roth IRA? Although an in-house conversion could be easier and you get to keep the money with your company, an in-house Roth might not offer as many investment options as you might want. But a bigger concern is that the tax provision does not allow you to re-characterize (undo) a conversion. Therefore for example, if you convert and then realize you don’t have the money to pay the additional income tax, you’d be in a heap of do-do. The bottom line: If you want to move 401(k) pre-tax funds to a Roth, you’re probably better off going to a Roth IRA rather than an in-plan Roth. Best wishes, George

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