401k plan sponsors can now offer participants the ability to convert pre-tax contributions to Roth contributions. This may be an attractive option in light of potential changes on the tax horizon.
The recently passed American Taxpayer Relief Act (ATRA) gives plan sponsors the ability to offer participants the option to convert pre-tax contributions to Roth contributions. This applies to plans that have a Roth option and allow in-plan conversions. Previously, the option to convert to Roth contributions was only available to those participants who were already eligible for rollover distributions. The ATRA now gives the option to convert pre-tax contributions to Roth contributions whether or not the contributions are currently distributable.
The difference between pre-tax and Roth contributions
Pre-tax contributions are those made from a participant’s pay before taxes are imposed. These contributions are taxed when distributions are taken, not at the time the contribution is made. Earnings from these contributions are also taxed upon distribution.
After-tax or Roth contributions are taken from a participant’s net pay, or the pay after taxes are imposed. 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 Pre-tax Contributions to Roth
If a participant elects to convert some or all of their pre-tax contributions to Roth contributions, these amounts would be taxed on the year of their conversion. As Roth contributions, they would not be taxed upon distribution. The earnings on those distributions would also not be taxed if the two requirements stated above are 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 Roth contributions. Those who wish to offer this option must amend their plans to include it within the year they intend to offer it. This option to convert to Roth contributions gives participants an expanded ability to manage their tax exposure.