Converting to Roth Contributions within a 401k

Effective January 1, 2013, the American Taxpayer Relief Act provides the option for participants to diversify their tax exposure when taking plan distributions.  The Act enables 401k plan sponsors to offer participants the option of converting pre-tax contributions to after-tax or Roth contributions. 

Recent changes make conversion possible

Conversion to Roth contributions was previously allowed, but only within a limited scope.  In 2010, the Small Business Act allowed for Roth conversions to occur, but only if the pre-tax contributions were already distributable.  Those who were age 59 ½ and over, for example, were able to take advantage of this option because their distributions were already eligible for rollover.  The ATRA now allows all pre-tax contributions to be converted to Roth contributions whether or not the amount is currently eligible for distribution.

Pre-tax contributions are defined as those made on a pre-tax basis.  These contributions are from a participant’s pay before taxes are taken.  While taxes are not taken at the time of contribution, the money is taxed upon distribution.  Earning from these pre-tax contributions are also taxed at the time of distribution.

Roth contributions are also called after-tax contributions because they are made from a participant’s net pay, or after taxes have been imposed.  These contributions, unlike pre-tax ones, are not taxed at the time of distribution.  Earnings from these contributions are also not taxed upon distribution if:

• The distribution is taken after the end of a five year tax period which begins at the time of the first Roth contribution
•  The distribution is taken when the participant reaches age 59 ½, or is disabled or deceased

Taking advantage of Roth conversions

If a participant chooses to convert a pre-tax contribution to a Roth contribution, a tax will be imposed in the year of conversion.  However, because it becomes a Roth contribution, it will not be taxed at the time of distribution.  Earnings from the contribution will also not be taxed upon distribution if it follows the two guidelines from above. 

The passage of the ATRA gives sponsors the opportunity to offer this option to participants.  Plan sponsors who wish to add this feature must amend their plans within the year that they wish to offer it.