IRS Guidelines on Roth 401(k) Conversion Rules

Effective September 27, 2010, as part of the Small Business Jobs Act of 2010, 401(k) and 403(b) plan sponsors may allow participants to convert their traditional 401(k) accounts to Roth accounts. For New York individuals thinking about converting from a traditional 401(k) to a Roth 401(k), there may be tax savings in the long run when people take money out of the retirement plan to leave it for their heirs, though there may be an upfront tax payment.

According to IRS guidelines, a Roth conversion allows participants to include the amounts in gross income for federal tax purposes in the year of conversion, versus wait until the year the amounts are distributed from the plan. The conversion is a tax planning tool for some people.

Before the Small Business Jobs Act of 2010, people who converted to a Roth account had to take a distribution from the 401(k) plan and roll the distribution to another 401(k) plan with a Roth feature. By analogy, a Roth IRA accelerates tax and allows future earnings to accumulate tax free.

Under the Small Business Jobs Act of 2010, participants in Roth 401(k) and 403(b) plans are immediately taxed. To let people make in plan conversions, the employer plan must already have a designated Roth option. The funds included in gross income after an in-plan conversion is the fair market value of the distribution, minus any basis the individual may have in the distribution. If the funds converted include an outstanding loan, the loan balance will be included in gross income. The Roth conversion is not subject to federal income tax withholding. Individuals who do not want to make estimated quarterly taxes may increase their withholding rate on earnings.

In a Roth, individuals do not get any tax savings from contributing to 401(k) or 403(b) plans as in traditional accounts. Even though people do their taxes only once a year, taxes are owed when due. When people do not pay enough tax throughout the year, they are subject to underpayment penalty even when they make up the payments at the end of the year

The in-plan Roth conversion will likely be subject to tax in the year of conversion. For 2010, funds converted to a Roth account in 2010 will not be taxed in 2010 unless a person elects. The taxable income splits between 2011 and 2012 and taxed at the rate applicable for those years. For someone making less money in the future, converting to a Roth feature may be the direction to take.

Tax laws may be complicated, engage an experienced New York tax attorney to maximize tax savings.