Many 401(k) account owners don’t realize they may be able to convert these accounts to Roth IRAs. The opportunity to convert traditional IRAs to roth iras now is well-known. We’ve been helping readers plan for it since 2008. The law now also allows the conversion of most employer-sponsored defined contribution plans to Roth IRAs.
There are two broad groups of employees who can take advantage of the opportunity.
One group of beneficiaries is of former employees who left 401(k) accounts at their old firms. Perhaps they forgot about them or didn’t get around to rolling them over to traditional IRAs or new employer plans. Or they may have liked the plan features and decided to keep their accounts. These accounts now can be converted to Roth IRAs.
The other group is current employees who are allowed under their plans to take “in-service distributions.” These are distributions by employees who still are at the firm and plan to stay there. The tax law allows in-service distributions of all account balances after age 59½. Employees younger than 59½ are allowed in-service distributions of any money they rolled over from a previous plan, plus employer-matching and profit-sharing contributions and their own after-tax contributions (but not their pre-tax contributions and investment earnings). In-service distributions can be rolled into Roth IRAs, resulting in a Roth IRA conversion.
You have to check your plan documents. While the tax law allows these in-service distributions, the plan doesn’t have to allow them. Check with your plan administrator to see if in-service distributions are allowed and what the limits are.
Most of the rules, benefits, and disadvantages of a traditional IRA conversion apply when a 401(k) account is converted to a Roth IRA. You pay a tax on the conversion just as though a distribution were made directly to you. After the money is in the Roth, future qualified distributions are tax-free. You also can convert as much or as little of the account as you want, or convert the account in stages over several years.
There’s a twist to the law for 401(k) conversions that can make the conversion more beneficial than a rollover or an IRA conversion.
Suppose your account has after-tax contributions. These would be tax-free if you withdrew them, and they are not taxed when they are converted to a Roth IRA. When you convert less than the full account, a pro rata portion of the converted amount is considered to be the after-tax contributions and the rest the before-tax amounts that are taxable on conversion.
With IRA conversions when there are after-tax contributions, you add up the balances of all your IRAs and divide those into the after-tax contributions in all your IRAs to determine the pro rata amount. You use the amounts for all your IRAs even when you are converting only part of one IRA. But for 401(k) conversions, each account is considered separately when calculating the tax-free portion. If you have multiple 401(k) accounts and IRAs, none of those amounts are used to compute the non-taxable portion of 401(k) account you are partially converting.
Some people want to convert only the after-tax contributions in their accounts. They want to transfer those amounts tax-free to Roth IRAs and leave the rest in their 401(k) or roll them over to a traditional IRA. The income and gains from investing the after-tax contributions compound tax-free, and then all of the Roth IRA eventually is distributed tax-free either to the owner or to heirs.
Unfortunately, the IRS hasn’t given clear rules on how to make this work. There are some strategies being advised by different tax and investment advisors. Some have been vetoed by the IRS, and the IRS hasn’t specifically approved any of them so far. You can find a good, thorough analysis of the different strategies at www.fairmark.com.
When your 401(k) plan includes employer stock, you have to be careful when doing a conversion to a Roth IRA.
Remember the tax law has a special benefit when appreciated employer stock is distributed from a 401(k) plan call NUA, or net unrealized appreciation. (See our November 2007 visit.)
When a 401(k) account is being closed after the employee separates from the employer’s service, turns age 59½, dies, or becomes disabled, the transaction should have two parts. The employer stock should be distributed directly to the owner (really to his taxable brokerage account). The rest of the IRA should be rolled over to a traditional IRA or converted to a Roth IRA. At that point the employee pays tax only on the tax basis, or original cost, or the employer stock. The appreciation is not taxed until the shares are sold, and then it is taxed at long-term capital gains rates. To get the favorable NUA treatment, the distribution must be a qualified lump sum distribution. That means the entire account must be distributed in the same calendar year.
The NUA opportunity is lost if the employer shares are transferred to a Roth IRA. In that case, the employer stock is treated the same as the rest of the converted 401(k). The current value is included in gross income and taxed. If employer shares are in your 401(k), you don’t want to transfer them to a Roth IRA, except perhaps if there is little or no appreciation in them.
July 2010. RW
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