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Roth 401(k) Conversions Explained

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Earlier in 2013, with the passage of ATRA (American Taxpayer Relief Act) there was a provision to loosen the rules for 401(k) plan participants to convert monies in those “regular” 401(k) accounts to the Roth 401(k) component of the account.  Prior to this, there were restrictions on the source of the funds that could be converted, among other restrictions.  These looser restrictions apply to 401(k), 403(b) and 457 plans, as well as the federal government Thrift Savings Plan (TSP).

Recently, the IRS announced that guidance was available to utilize the new conversion options.  As long as the 401(k) plan is amended to allow the conversions, all vested sources of funds can be converted, even if the participant is not otherwise eligible to make a distribution from the account.

This means that employee salary deferrals, employer matching funds, and non-elective payins to the 401(k) account can be converted to a Roth 401(k) account (as long as the plan allows it).  Previously, only employee deferrals were eligible to be converted, and then only if the participant was otherwise eligible to make distributions from the 401(k) account, such as being over age 59½ (if the plan allows) or having left employment.

The converted funds will remain under the purview of the 401(k) plan’s distribution restrictions.  Administrators of 401(k) plans can choose to amend their plan to allow these new conversion options or limit existing conversions as they see fit.

Any conversions will cause the converted funds to be included in your ordinary income for the tax year of the conversion, most likely triggering income tax on the additional ordinary income.  If you don’t have funds outside the 401(k) plan to pay the tax on the conversion, the whole operation becomes less attractive, since you’re having to take a (presumably) unqualified distribution of funds to pay the tax on the conversion.  In the future, qualified distributions from the Roth 401(k) account will be treated as tax-free (as with all Roth-type distributions).

For example, if you have a 401(k) account with $100,000 in it and you wish to convert the entire account to your company’s Roth 401(k) option.  If your marginal tax bracket for this additional income is 25%, this means that you would have a potential tax burden of $25,000 on this conversion.  If you have other sources to pull this $25k from, then you can convert the entire $100,000 over to your Roth 401(k) plan.

However (say it with me: “there’s always a however in life”), if you don’t have an extra $25,000 laying around to pay the taxes, you might need to withdraw the money from your 401(k) plan to pay the tax – which would also trigger a penalty on the withdrawal of an additional $10,000.  So now your conversion has cost 35% overall – and the chance of such a conversion paying off due to higher taxes later becomes less likely.

And then there’s the additional rub: most 401(k) plans have significant restrictions on taking an in-plan distribution such as the one mentioned above to pay the tax.  Your plan may allow the Roth 401(k) conversion distribution, but not the regular distribution while you’re participating in the plan, so you’re stuck – and will be stuck with a huge tax bill the following April.

Did the Advent of 401(k) Plans Hurt Americans?

The 87-vehicle pile up on September 3, 1999

The 87-vehicle pile up on September 3, 1999 (Photo credit: Wikipedia)

There’s been quite a bit of press lately about the recent Economic Policy Institute study (see this article “Rise of 401(k)s Hurt More Americans Than It Helped” for more), which indicates that the 401(k) plan itself is the cause of American’s lack of retirement resources.  I think it has more to do with the fact that the 401(k) plan (and other defined contribution plans) were expected to be a replacement for the old-style defined benefit pension plans, and the fact that those administering the retirement plans did little to ensure success for the employees.

Traditional defined benefit pension plans didn’t ask the employee to make a decision about how much to set aside – this was determined by actuaries.  Then the company made sure that the money was set aside (in most cases) so that the promised benefit would be there when the employee retires.  In the world of 401(k) plans, the employee has free choice to decide how much and whether or not to fund the retirement plan at all.  Human nature kicks in, and the nearer term needs of the employee win out over long term needs – of course the long-term requirements get short shrift!

It’s the same as when we turn over the car keys car to a 16-year-old.  Up to this point, the child has just ridden along, not having to know anything about rules of the road, car maintenance, or paying attention.  You wouldn’t just toss Johnny the keys and say “You know where you want to be. Do your best to get there!”  Of course you’re going to make sure that he has all the training necessary to operate the vehicle safely, and that he knows when to put fuel in the car, as well as that he knows how to navigate to his destination on time.

If the playing field had been level – that is, if when 401(k)-type plans were introduced as replacements for pension plans that there was no choice regarding participation and funding level, we’d see a much different picture.  I don’t think education alone is the answer, because the importance of continual funding is so difficult to comprehend.  Forced participation runs counter to the “American Way”, but that would have changed our outlook dramatically.

The problem isn’t the 401(k) plan itself – it’s that when companies dropped pension plans in favor of 401(k) plans they didn’t provide employees with the correct message about the importance of participation.  Free will is a good thing, don’t get me wrong.  But I think employers could have done much, much more to emphasize the importance of participation, of making long-term investment decisions, and of providing for your future with today’s earnings.

It wasn’t the account that is the problem, it’s in the implementation.

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Rolling Over a 401(k) into a New Employer’s Plan

Beethoven

When you change jobs you have a choice to make regarding your retirement plan at former employer.  If the plan is a 401(k), 403(b), or other qualified plan of that nature, you may have the option to roll the old plan into a plan at your new employer.

The new employer’s plan must allow rollovers into the plan – this isn’t always automatic.  Most plans will allow rollover of former employer’s plans, but not all.  Once you’ve determined that the plan will accept a rollover, you should review the new plan to understand whether or not it makes sense to roll your old plan into it, or choose another option.  Other options may be: rollover the old plan into an IRA, convert the old plan to a Roth IRA, leave the old plan where it is, or take a distribution from the old plan in cash.

In this article we’ll just deal with rolling over the old plan to your new plan.

If the new plan has some compelling features, such as access to very low cost institutional investments or attractive closed investment options, or if the plan has very low overhead and great flexibility, you might want to rollover your old plan into it.  Other reasons that might compel you to rollover the old plan might be – to have access to loan features (IRAs don’t have this), access to your funds when leaving your employer after age 55 but before age 59½, and ERISA protection against creditors.

There may be reasons to leave your old plan at the old employer though.  The two that come to mind are NUA treatment of stock of the old employer, and if you think you’ll need access to the funds before you leave the new employer (especially if you’ve left that employer after age 55).

So after reviewing the options and features, you’ve decided to rollover the old plan to the new employer’s plan.  It’s a relatively straightforward process:  you contact the old plan’s administrator and request a rollover distribution form. You should have already contacted the new plan’s administrator to ensure that the new plan will accept a rollover.  Once you have the rollover distribution form from the old employer, get any pertinent information from the new employer, such as your employee id, or an account number for the new plan.

On the rollover distribution form, you’ll have the option to send the distribution directly to the new plan – called a trustee-to-trustee transfer.  In this manner, the funds never come into your possession.  This is important, because if you take distribution in cash from the old plan, the IRS requires that 20% is automatically withheld from the distribution.  You could still send the distribution to the new plan – but you’d have to come up with the 20% that was withheld in order to make the transfer “whole”.  It’s not required that you make a complete transfer, but if you take any of the funds in cash, including the withheld 20%, this money will be taxable as ordinary income, and if you’re under age 59½ it will likely also be subject to an additional 10% penalty.

After all of this has occurred, your new plan will have the additional old plan money rolled into the account.  Most likely this will be entirely in cash when it arrives in the account – so you will need to make investment allocation choices for the new addition to the account.

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Join in the Movement – Add 1% to Your Savings This Year!

Retirement

Over the past several weeks we’ve been writing articles to encourage all Americans to add at least 1% more to savings in the coming year. More than 20 of my fellow bloggers have submitted articles, and these articles include many great ideas that you can apply in order to increase your savings rate in the coming year.

Since many employees are going through annual benefit elections right about now, it’s a very good time to increase your annual contributions to your retirement savings plans. Big changes are easiest to undertake with incremental steps – starting with adding 1% can have a great impact and get the momentum going!

Listed below are all of the articles that I’ve been notified about so far – 22 23 in all! These folks are very smart, and have shared some great ideas. You owe it to yourself to check it out, and then take action!  Add that 1% to your 401(k) or IRA!  If you’re a blogger, see the original post for details on how to join the action: Calling All Bloggers!

Listed below are the articles in our movement so far (newest are at the top):

A video tv segment from Laura Scharr: Preparing for Retirement

From Paula Hogan: 6 Ways to Add Another 1% of Income to Retirement Savings in 2013

From Kevin O’Reilly: From TwentySomething to Millionaire

From Tom Batterman: Take the 1% Challenge in 2013!!!

From Dana Anspach: Can You Spare A Penny?

From Steve Doster: The Easy Way to Become a Millionaire

From Nancy Anderson: Save 1% More for Retirement in 2013

From Kathy Stearns: Do the 1% in 2013!

From Ken Weingarten: The 1% Challenge (Should you dare to accept)

From Richard Feight: The 1% Challenge!

From John Hunter: Save What You Can, Increase Savings as You Can Do So

From Emily Guy Birken: Increase your savings rate by 1%

From Jonathan White: Ways to increase your retirement contributions 1% in 2013

From Alan Moore: Financial Challenge – Should You Choose To Accept It

From Ann Minnium: Gifts That Matter

From Laura Scharr: In Crisis: Personal Savings- Here Are Six Steps to Improve Your Retirement Security

From yours truly: Add Your First 1% to Your 401(k)

From Steve Stewart: Seriously. What’s 1 percent gonna do?

From Theresa Chen Wan: Saving for Retirement: The 1% Challenge for 2013

From Mike Piper: Investing Blog Roundup: Saving 1% More

From Robert Wasilewski: Increase Savings Rate By 1%

From Sterling Raskie: A Nifty Little Trick to Increase Savings

From Roger Wohlner: Need Post-Election Financial Advice? Try the 1% Solution

From Michele Clark: Employer Retirement Accounts: 2013 Contribution Limits

Thanks to all who have participated so far – and keep those links coming!

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2 Good Reasons to Use Direct Rollover From a 401(k) Plan

If you have a 401(k) plan (or any Qualified Retirement Plan (QRP) such as a 403(b) plan), when you leave employment at that job you can rollover the plan funds to an IRA or another QRP at a new job.  Listed below are 2 very good reasons that you should use a Direct rollover (also known as a trustee-to-trustee transfer) instead of the 60-day rollover.

Red Flower
Image by aloucha via Flickr

A 60-day rollover is where the former plan distributes the funds from your account to you, and in order to make the rollover complete you must deposit the entire distributed amount into the new plan or IRA within 60 days.

Reasons to Use a Direct Rollover

  1. You must complete the rollover to the new account or IRA within 60 days.  There is little if any leeway on this 60-day period – and though it seems as if this is a simple task to accomplish, there are many cases where well-intentioned individuals missed the bus on this one.  All it takes is a lost letter in the mail, or the check falling through the cracks, or any of myriad ways to miss the deadline.
  2. When funds are distributed from a QRP to an individual, the plan administrator is required to withhold 20% of the distribution for income tax.  This presents a problem if you were planning to rollover the full amount of the QRP into your new plan or IRA, since you’ll now need to come up with the missing 20% from other sources.  Granted, if all things remain the same you should get the withheld 20% back from the IRS when you file your taxes, but that could be a long wait if you don’t have a lot of excess cash lying around.

Using the direct rollover eliminates both of the issues listed above.  When then QRP administrator enacts a direct rollover for you, most often the distribution is directly to the administrator or custodian of the new plan or IRA.  Sometimes the QRP administrator will send a check to you, the plan participant, made out to the new administrator or custodian, so you’ll still need to make sure that the check gets to the new plan within the 60-day window.  You’re in a much better position to get around the 60-day window if the check is made out to the new custodian, since technically the 60-day rollover requires that you have the funds at your disposal (for use or deposit in another account).

In addition, using a direct rollover eliminates the 20% withholding requirement altogether.  There’s no amount to make up later.

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