The Fiscal Cliff: a buzzword that has everyone talking (even though most don’t know what they’re talking about). If you haven’t heard of the Fiscal Cliff – Welcome! This must be your first time on the internet.
For those of you who’ve heard about it in passing, you’ve probably caught wind of words like “unemployment” and “spending cuts” and “Thanks, Obama.” But it isn’t all bad – we promise.
Though there are a number of tax increases, the new fiscal cliff deal also offers a change to 401(k) plans, offering a way to reduce your taxes on your retirement plan in the long run.
The amendment to the American Taxpayer Relief Act of 2012 states, “Amounts in applicable retirement plans may be transferred to designated Roth accounts without distribution.”
Those with a traditional 401(k) plan may roll over their contributions into a Roth 401(k) account (pending employer approval) to take advantage of the current, record low tax rates even if they’re still employed or not otherwise eligible for distributions.
This amendment is expected to generate $12 billion in tax revenue in the next ten years. Where will that money come from? Your pocket, of course! But that’s not necessarily a bad thing (in the long term, anyways).
Previously, those with a traditional 401(k) could only transfer their accumulated contributions into a Roth 401(k) account under limited circumstances—one needed to be at least 59 ½ years old, leaving a company or otherwise eligible for distributions.
The recent Fiscal Cliff deal has eliminated those limitations and are now allowing employers to make an “in-plan” conversion option available to employees. This applies to 401(k) plans in addition to 403(b) and 457(b) plans.
The catch? You’ll need to pay taxes on the converted amount upfront. This allows your new Roth account to continue to grow tax-fee, and eliminates taxes on future distributions. These upfront taxes must be paid with funds outside of the 401(k) account, so if you don’t quite have that cash on hand, this new opportunity may be out of your reach.
To Roll or Not to Roll?
First, one must consider two questions:
- Can I afford the upfront taxes on the conversion amount?
- Do I expect to be in a higher tax bracket in the future?
If you answered yes to both questions, conversion would be a wise choice. If you can pay the upfront taxes, then rolling your contributions into a Roth 401(k) would be a great opportunity to take advantage of low tax rates. Also, according to CPA Ryan Blume, the conversion would be a great option for “those in a relatively lower income tax bracket now but expect to migrate to a higher tax bracket by the time they retire (i.e. they are relatively early in their careers).”
If you can’t afford the tax on the conversion, you’re in a higher tax bracket or anticipate remaining in the same or lower bracket until retirement age, a conversion wouldn’t offer the best tax option. If you see your tax situation getting better or staying the same in the future, stick to your non-Roth plan and enjoy a tax break now.
How much would I need to pay?
It’s fairly easy to find out how much you’d need to pay in upfront taxes—you just need to know what tax bracket you’re in and how much you’d like to roll over.
For example, Nerdy Ned is 50 years old, is in the 28% tax bracket and has saved up $10,000 in his 401(k) account. If he were to convert all $10,000, he would pay $2,800 in taxes upfront (10,000 x 28%).
Again, the tax payment must be paid with funds outside of the 401(k) account, so be sure this is a reasonable expense.
Take Taxes Into Your Own Hands
With this new “in-plan” conversion option, you’re given the opportunity to take more control over your tax situation. You can choose to roll over just a portion of your 401(k) account, allowing for a diversity of accounts that will let you manipulate your tax situation in retirement.
Just be sure to remember the Roth conversion will modify your adjusted gross income, meaning you will now pay taxes on contributions on the front end as opposed to when you receive distributions.
Tax talk may be a pain, but remember that with some careful and early planning, you’ll be doing your future self a huge financial favor.
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