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because, assuming the same investment return, both alternatives should result in the same after-tax income when withdrawn in retirement.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.
Although the fiscal cliff legislation settled the question of rates generally—holding rates the same for many, and raising them for different groups with higher incomes—already there is discussion of tax rates being considered in upcoming debt ceiling discussions. The threat of potential rate increases may be greater, however, for higher incomes.
Those with higher incomes may be in a better position to pay taxes on a Roth conversion out of other assets. However, their ability to evaluate the pre-tax and Roth alternatives has become more complicated in light of recent changes, including:
- An additional 3.8% tax on certain investment income for individuals with income over $200,000 (joint filers earning more than $250,000). While this tax would not apply to a Roth conversion, the taxable income resulting from the Roth conversion would be counted in determining whether this additional tax applies.
- Phase-outs for personal exemptions and deductions beginning with individuals with income over $250,000 (joint filers earning more than $300,000). The taxable income resulting from the Roth conversion would be counted in determining whether this applies.
- Higher marginal tax rates and higher capital gains rates for individuals with incomes over $350,000 (joint filers earning more than $400,000). The taxable income resulting from the conversion would be counted in determining whether these higher rates apply, and any such higher rates would apply to that taxable income.
Each of these would need to be evaluated both for the year of the proposed conversion and the year of the retirement distribution. For individuals with incomes well below the respective thresholds, or already in excess of those thresholds, these new rates should not affect the conversion decision. For those whose incomes are below the threshold by less than the amount of the contemplated Roth conversion, a more complex weighted average rate is likely to be necessary. And in those cases where a large proposed Roth conversion would take them across multiple tax bracket thresholds, the weighted average becomes even more complex. Alternatively, smaller conversions over multiple years may not raise the same concerns.
It also should be remembered that additional considerations, beyond tax rates, affect an individual’s decisions. One such consideration may be tax diversification, to help manage taxes on retirement income. In any event, with respect solely to taxation, two general observations stand out:
- Individuals in the lower income brackets may have a greater incentive to select a Roth conversion, but may not have sufficient resources to pay the taxes outside of the plan.
- Individuals in the higher income brackets may have resources to pay the taxes outside of the plan, but may be uncertain as to whether the Roth conversion is advantageous.
- Spreading out Roth conversions over multiple years might make each installment more affordable and create fewer complexities.
Richard Turner, vice president and deputy general counsel, VALICNOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.