The benefits of Roth Conversions

Taxes have gone up and may well go up some more.  The recent tax increase on those making over $400,000 will do little to reduce the deficit.  The REAL money is with the millions of people making less.  The problem with IRAs and 401(k) plans is that the money that’s withdrawn in the future is taxed as ordinary income.  The money withdrawn from a Roth IRA or 401(k) is not taxed when withdrawn. 

Hidden in the fine print of the “Fiscal Cliff” legislation is a provision that allows people to convert funds in their 401(k) accounts into Roth 401(k) accounts without many of the limitations that were formerly imposed on these conversions. 

The American Taxpayer Relief Act of 2012 (the Act) allows 401(k) plan participants to convert funds held in their traditional 401(k)s into Roth 401(k)s. Like an IRA-to-Roth-IRA conversion, this move allows 401(k) account owners to pay the taxes on the funds when they are rolled over into the Roth—so that the funds can then grow tax-free within the Roth, where they can be withdrawn without tax liability in the future. The Act does not impose any limits on the amount that can be transferred from the 401(k) to the Roth.

These types of rollovers were always permitted, but, under prior law, a 401(k) account owner was permitted to convert only the funds that he could otherwise withdraw without penalty. This limitation effectively confined conversions to those people who had already reached age 59 ½, or who had died, become disabled, or separated from service. Other people were required to pay a 10% penalty if they converted where distributions were not otherwise permitted.

Conversions could be highly beneficial for younger savers. These people may not have reached their full earning potential and may fall into a lower tax bracket today than they expect to reach later in life. Further, these taxpayers have a longer period before retirement, meaning that the funds converted will have more time to grow tax-free within the Roth.

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