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The New Fiscal Cliff Law and Your Retirement

A wrinkle in the legislation could lower your taxes on 401(k) retirement savings

By Robert M. Kaplan | January 11, 2013
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Robert M. Kaplan is vice president and national retirement consultant for ING U.S. He has 30 years of experience in the retirement industry, offering his expertise on regulatory topics, retirement plan design, administration and sales strategies.

While most of the attention to the “fiscal cliff” legislation focused on increased tax rates for people with the highest incomes, you might find one little-noticed provision helpful for your retirement and an option to consider for long-term tax planning.

A New 401(k) Wrinkle

The new law lets workers with employer-sponsored 401(k), 403(b) or governmental 457 retirement plans roll over any portion of their account balances into Roth retirement accounts, if available within the same plan.

(MORE: Watch Out: Your 401(k) Is Being Targeted)

Unlike a traditional 401(k), where taxes on contributions and earnings are deferred until the money is withdrawn, Roth contributions are taxed upfront but can then generally be withdrawn tax-free at retirement. (The legislators added the Roth provision to the fiscal cliff law because they think it will raise roughly $12 billion in tax revenue over 10 years.)

Converting your retirement money into a Roth could be worth considering if you expect your tax rate to be the same or higher in retirement than it is today — you’d generally avoid a tax bill on your withdrawals at that point.

Before the passage of the fiscal cliff law (technically called the American Taxpayer Relief Act of 2012), participants in employer-sponsored plans could only roll over their money into Roth 401(k)s if they qualified for what’s known as a “distributable event,” such as a job change to a different firm, turning 59½ or retirement.

Employers Likely to Amend Retirement Plans

Currently, more than 40 percent of employers offer the Roth feature, but many industry experts expect that figure to rise as more employees request this retirement-plan option.

(MORE: Why the U.S. Budget Isn’t Like Yours)

The new Roth conversion rules became effective Jan. 1, though if your plan permits this strategy, you may be allowed to transfer money you contributed in the past to a Roth in the same plan.

That said, this provision raises a host of potential tax issues for participants and operational issues for plan sponsors and administrators. Employers and employees will have to wait for the Department of the Treasury (and possibly the Department of Labor) to issue corresponding regulations spelling out the details. Once the rules are clarified, you may have new options to consider as part of your long-term tax planning strategy. 

Whether a Roth Conversion Is Wise

A key consideration to determine if a Roth conversion makes sense is your ability to pay the taxes that will be due at the time. 

For example, if you are in the 25 percent tax bracket and want to convert $100,000 to a Roth but would have trouble coming up with the money to pay the accompanying $25,000 tax bill, you may want to roll over less than $100,000 and reduce your tax liability on the conversion.

Before converting any pre-tax money to a Roth account, you should also evaluate whether any potential tax benefit in the future outweighs the benefit of keeping the money in a traditional 401(k) or similar employer-sponsored plan.  It’s a good idea to review your options with a financial professional to discuss how a conversion could impact your retirement savings and taxes — both in the short term and the long term.

(MORE: Obama’s Second Term and Older Americans)

What Hasn’t Changed — Yet

For now, at least, you can breathe a sigh of relief that the long-standing tax advantages of workplace retirement plans have not been curbed or eliminated.

The new law doesn’t reduce or eliminate the maximum amount you can contribute to a plan this year ($17,500; $23,000 if you’re 50 or older) or the tax deferrals on your account earnings. Nor does it treat your retirement plan contributions as taxable compensation; the money you invest still goes in pre-tax. (As Next Avenue has noted, however, Washington has its eye on trimming 401(k) plans in the future.)

So, if you’re allowed to contribute to a workplace retirement plan, try to stash away as much money as you can to help build greater financial security for your future.
 
This information is provided as general guidance. It is not intended to be legal or tax advice. You should contact your legal and/or tax advisers regarding the facts and circumstances around your retirement plan and the applicability of the issues discussed in the communication.
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