New Law Allows Roth 401(k) Conversions

Employees can delay taxes on Roth 401(k) rollovers in 2010.

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The Small Business Jobs Act of 2010, signed by President Obama last week, may boost Roth 401(k) balances. A little-known provision of the new law, which went to affect on Sept. 27, 2010, allows workers to convert their traditional 401(k) or 403(b) account to a Roth in the same plan if their employer offers one. Employees must pay income tax on the amount converted.

[See 10 Costs That Could Increase in Retirement.]

Roth 401(k) conversions will have the same one-time tax perk in 2010 as Roth IRA conversions. Employees who make transfers this year can choose between paying the tax this year or paying tax on 50 percent of the income in 2011 and the second half in 2012. In future years the tax must be paid in the year of the conversion.

Retirement savers who use a Roth 401(k) pay the taxes up front and distributions in retirement from accounts at least 5 years old are tax-free. Pre-paying the taxes can be especially beneficial for young people, workers in low tax brackets, and those who plan to pass on money to heirs. In contrast, traditional 401(k)s give you a tax break in the year you save for retirement, but income tax is due upon withdrawal.

[See 10 Reasons to Open a Roth IRA.]

Participants who roll over all or part of their nest egg to a Roth 401(k) in 2010 have until the due date of their federal tax return, including extensions, to decide in which year or years to pay the income tax. Estimated taxes may be due on the amount converted. Those who fail to pay estimated taxes could incur an underpayment penalty at tax time.

In past years, rollovers to Roth accounts were limited to Roth IRAs. Those under age 59 ½ could generally only convert after leaving their job. The new law also permits government 457(b) plans to add a Roth option beginning in 2011.

[See Who Should Convert an IRA to a Roth IRA.]

Roth 401(k) accounts are catching on among employers. Approximately 29 percent of companies currently offer a Roth 401(k), according to recent Hewitt Associates survey of employers. Another 25 percent of firms say they are likely to add the feature this year.

Continuing to save in a Roth 401(k) has a few clear advantages over investing in a Roth IRA. 401(k)s have much higher contribution limits than IRAs. Employees can save up to $16,500 in a Roth 401(k) in 2010, or $22,000 if they are age 50 or over. Roth IRA account owners can contribute just $5,000 each year, which jumps to only $6,000 after age 50. Saving in a Roth 401(k) also allows you to take advantage of your employer’s 401(k) match. Roth IRAs, however, generally give you a wider variety of investment options.