This has given rise to a number of questions, falling into two main categories:
- Will guidance be forthcoming (and will it be needed) to address implementation questions? Such questions may include:
- The timing and form of plan amendments, if any; and,
- The need, if any, to maintain separate in-plan Roth conversion accounts by contribution source, to facilitate application of different withdrawal restrictions.
- Who is most likely to benefit from such a conversion, and who is least likely?
This article will focus on the second category.
Much has been written about the potential advantages and disadvantages of Roth conversions generally, whether intra-plan or through rollover to a Roth IRA. Just to recap a few basics:
- The average participant should be indifferent between pre-tax and Roth – at least for tax purposes – if they expect their marginal tax rates to be the same currently and in retirement, and they pay the tax on the Roth contribution or conversion out of the amount to be contributed or converted, thus reducing the resulting Roth balance. This is true as long as the Roth qualification period is satisfied because, assuming the same investment return, both alternatives should result in the same after-tax income when withdrawn in retirement. If tax rates are expected to be higher in retirement, the advantage goes to the Roth. If they are expected to decrease, pre-tax has the advantage. For purposes of the comparison, in the case of amounts that may cross multiple total marginal rates a weighted average should be used for the pre- and post-retirement comparison.
- If the account value being converted to a Roth account is not eligible for a distribution, the taxes cannot be paid from the conversion, and thus must be paid from outside funds.
- If the taxes on the contribution or conversion are paid from outside funds, and if that does not result in additional taxable income (e.g., taxes are paid from after-tax savings), that generally gives the Roth conversion an advantage because it does not reduce the pre-tax accumulation and it increases the after-tax value of that accumulation in retirement (assuming a qualified distribution). This is true even if you take into account the opportunity cost of the outside savings, if you assume those savings would have enjoyed the same return (before taxes) as inside the plan. If tax rates are expected to be lower in retirement, whether it is better to pay taxes now or later may depend on the magnitude of the tax rate difference and the amount of time between the conversion and retirement.
With all of that in mind, we can look at the potential benefits or costs of a Roth in-plan conversion of amounts not currently eligible for a distribution. For starters, and as noted above, one key consideration is expectations for the relative direction of tax rates in retirement – are they expected to be higher or lower than currently? This particular question actually contains at least two sub-questions: does the individual expect to be in a higher, lower, or the same tax bracket as today, and do they expect rates generally to go up, down, or stay the same? Both involve some critical guesses about what the future holds. For individuals currently at the lower (or lowest) rates, the chances of rates rising are higher, and vice versa. This presents some important challenges.
Example: Jane has a $50,000 account balance in her 401(k) plan. The plan permits in-plan Roth conversions, and she is considering that option. Her current total marginal income tax rate (federal, state, and local) is 23%. She expects marginal rates affecting her to remain fairly constant, and she expects in retirement to have a lower total marginal rate of 20%. A Roth conversion is not likely to benefit her. Example: Andrew has a $30,000 account balance in his 403(b) plan, which also permits in-plan conversions.
He expects to be in a higher tax bracket in retirement, and he expects tax rates to stay the same or increase. He may benefit from a Roth conversion, if he has available after-tax funds to pay the taxes on the conversion.