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Roth Conversions for Retirement Plans

The 2012 American Taxpayer Relief Act passed earlier this year has a new opportunity for Roth conversions. Now individuals can convert any portion of their balance in an employer-sponsored tax-deferred retirement plan account into a designated Roth account under that plan.

Designated Roth accounts are popular retirement plan options because they offer several advantages, such as:

  • Earnings within the account are tax-sheltered. This is the same with a regular qualified employer plan or IRA.

  • But unlike a regular qualified employer plan or IRA, withdrawals from a Roth IRA aren't taxed if some relatively liberal conditions are satisfied.

  • Although a designated Roth account is subject to the same lifetime required minimum distributions as are regular qualified employer plans or IRAs, designated Roth account owners can avoid these distributions by rolling them over tax free to a Roth IRA, which is not subject to required minimum distributions.

  • Beneficiaries of Roth IRAs also enjoy tax-sheltered earnings. This is the same with a regular qualified employer plan or IRA. However, Roth IRAs also enjoy tax-free withdrawals, which a regular qualified employer plan or IRA don’t. But they do have to commence regular withdrawals from a Roth IRA after the account owner dies.

The catch under the new law conversion provision, and it's a big one, is that the conversion will be fully taxed. This is assuming the conversion is being made with pre-tax dollars or money that wasn't taxed to an employee when contributed to the qualified employer-sponsored retirement plan and the earnings on those pre-tax dollars.

For example, a taxpayer is in the 28-percent federal tax bracket and converted $100,000 from an employer-sponsored plan. This is funded entirely with untaxed dollars to a designated Roth account. They would owe $28,000 of federal tax. And that’s not factoring in the state tax yet.

So, in deciding whether to pursue a Roth conversion, one would need to weigh the price of paying tax now against the advantages of future tax-free withdrawals and freedom from the required minimum distributions rules.

Further, unlike conversions involving Roth IRAs, once done, a conversion to a designated Roth account cannot be undone or recharacterized.

The conversion option for retirement plans would only be available if employer plan sponsors include this feature in the plan. The provision is effective for post-2012 transfers in tax years ending after December 31, 2012.

Disclaimer: The items included in the Tax Tip Tuesday Video Blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advise contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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