Converting Pre-tax Contributions to Roth
The 401k plan now offers an “in-plan Roth conversion” feature. With this feature, pre-tax contributions can be converted to Roth within the 401k plan. This is an attractive option in light of the potential changes on the tax horizon.
The recently passed American Taxpayer Relief Act (ATRA) opened this option. Previously, only those participants who were already eligible for rollover distributions were able to convert their contribution to Roth. ATRA now gives the option to convert pre-tax contributions to Roth contributions whether or not the contributions are currently distributable. The plan must first have a Roth option and allow in-plan conversions.
Knowing the different types of contributions
Pre-tax contributions are made from a participant’s pay before taxes are imposed. These contributions reduce taxable income. Pre-tax contributions are taxed when distributions are taken, not at the time the contribution is made. Earnings from these contributions are also taxed upon distribution.
Roth contributions are made from a participant’s pay after taxes are imposed, or from a participant’s net pay. Roth contributions are not taxed upon distribution. Earnings from Roth contributions are also not taxed upon distribution if the following two requirements are met:
- The distributions are taken after the end of a “seasoning” period (currently a five-year period) which begins the year of the participant’s first Roth contribution
- The distribution is taken when the participant is 59 ½, disabled, or deceased
Converting to Roth
The participant must first elect to convert a chosen amount to Roth. This amount is taxed for the conversion year; it is included in the participant’s taxable income for the year.
As Roth funds, they would not be taxed upon distribution. The earnings on those distributions would also not be taxed if the two above requirements were met.
The American Taxpayer Relief Act allows plan sponsors to give participants the option to convert some or all of their pre-tax contributions. To offer this option, you must amend your plan within the year you wish to offer it. This option to convert to Roth contributions gives participants an expanded ability to manage their tax exposure.