U.S. workers willing to take tax pain today in exchange fortax-free gains on earnings in their 401(k) retirement accountslater 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any money in their tax-deferred accounts to aso-called Roth 401(k) account, if their employer offers one, whichcan be withdrawn tax-free in retirement. The change is projected toraise $12.2 billion in revenue over 10 years, according to theJoint Committee on Taxation, and help defray the cost of delayingspending cuts that had been set to take effect this month.

“This dramatically expands the number of participants who canuse this provision,” said Bob Holcomb, executive director oflegislative and regulatory affairs for JPMorgan Chase & Co.'sretirement plan services. “It will allow any amount to betransferred.”

The conversion opportunity can benefit people with significantbalances, the up-front money to pay taxes now with funds outsidetheir retirement account and years of tax-free earnings ahead ofthem or their heirs. Conversions to Roth 401(k)s had been limitedto certain funds and to plans that allowed the switches. The lawopens the opportunity to more workers who hold $5 trillion inemployer-sponsored defined contribution plans, including401(k)s.

Contributions to a traditional 401(k) account are tax-deferred,with taxes paid at ordinary income rates when the money iswithdrawn in retirement. When savers put money into a Roth 401(k)account, they pay taxes on the money upfront in exchange fortax-free withdrawals later.

The new conversion opportunity may help wealthy investors whowant to leave their retirement accounts to heirs and youngersavers, said John Olivieri, a partner in the private clients groupat 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 theiraccount if it's a small part of their net worth because they havemore time to make back the money they lose in paying the taxupfront, Olivieri said.

Fund Transfers

A provision in a 2010 law allowed some 401(k) participants toconvert part of the money in their plan to a Roth 401(k) account,with restrictions: Their employer had to offer a Roth 401(k) andallow conversions. Funds transferred were limited to money eligiblefor distribution, such as that held by savers age 59½and older, and some employer contributions, said Alison Borland,vice president of retirement solutions and strategies atLincolnshire, Illinois-based Aon Hewitt. It is a unit of Aon Plcthat administers 401(k) plans for about 5 million workers.

“Now they are saying you can convert any money,” said EdFerrigno, vice president of Washington affairs for the Plan SponsorCouncil of America. The Chicago-based group represents about 1,000employers that sponsor plans and lobbied for the 2010 law change asanother way for participants to diversify their savings, Ferrignosaid. The budget legislation may encourage more employers to offerRoth 401(k) accounts, even as questions remain about the logistics,he said.

“This isn't going to happen overnight,” he said. “Treasury isgoing to have to issue guidance. Plans are going to have to makeamendments.”

Americans held $5 trillion in defined contribution plans as ofSept. 30, including $3.5 trillion in 401(k)s, according to theWashington-based Investment Company Institute.

About 12 percent of plan sponsors offer and allow conversions toRoth 401(k) accounts and the majority of them don't charge a feefor it, Borland said. Participants should ask whether there's acost for such a transaction, she said.

A taxpayer in the top income bracket with a 401(k) worth $1million may pay 39.6 percent, or $396,000, in federal taxes thisyear when converting the entire account into a Roth 401(k). Thelegislation allows all or a portion of funds in an account to beconverted to a Roth within the same plan, Olivieri said. Once thetaxes are paid upfront, all of the additional earnings andappreciation in the account are tax-free, he said.

Congress has turned to Roth accounts before as a revenueraiser.

The government lifted income restrictions on converting anindividual retirement account, or IRA, under a provision of a 2006law that took effect in 2010. That's when U.S. taxpayers makingmore than $100,000 a year in adjusted income could start making thetransfers. There's no limit on conversions if an investor hasmultiple IRAs, nor a cap on the amount that can be shifted.

Fidelity, Vanguard

When the Roth IRA conversion rules changed, Internal RevenueService regulations allowed taxpayers to choose whether to pay allthe tax in 2010, or split it between tax years 2011 and 2012. Thelegislation passed this week didn't include a similar specificationon payment of taxes on conversions.

Fidelity Investments, the largest 401(k) plan provider, saw morethan 355,000 Roth IRA conversions from January 2010 to June 2012,according to Deborah Pont, a spokeswoman for the Boston-basedmutual-fund firm.

Vanguard Group Inc. saw 244,356 in conversions of traditionalIRAs to Roth IRAs to in 2010, a 91 percent increase from 2009before the income limits were lifted, according to Linda Wolohan, aspokeswoman for the Valley Forge, Pennsylvania-based firm.

The scope of possible conversions may be smaller at the startfor 401(k) plans because only about half of employers in 2011offered Roth accounts in their plans and most of those didn't allowconversions, according to Vanguard.

Fewer than 2 percent of plans administered by Vanguard haveopted to allow Roth 401(k) conversions and about 500 participantshave taken advantage of the move since the 2010 legislation, saidJean Young, senior research analyst at Vanguard's Center forRetirement Research.

“The thing to keep in mind is that when people do that type ofconversion they have to pay a tax,” Young said. “When they realizethey have to pay the taxes they tend to back off.”

A Roth conversion works best when an investor can pay the taxeswith funds outside the 401(k) so as not to deplete savings in theaccount, said John Sweeney, executive vice president of planningand advisory services at Fidelity.

Investors who are near or at retirement with a 401(k) balancethat is a large portion of their net worth that they need to spendin their remaining years rather than transfer to heirs shouldn'tmake the conversion, Olivieri said.

“It will take a chunk of your other money and it will take youawhile to earn it back,” he said.

People also should be aware that there's a chance, however slim,the government will lower taxes in the future. They should considerwhether they plan to retire in a place without state income taxes,which would reduce their total liability, Olivieri said.

“A lot of blind faith goes into this that if you pay the taxnow, you don't ever pay later,” he said.

Bloomberg News

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