Roth 401(k) Rollovers || 401(k) Plans

September 28, 2010

Last month I wrote about how certain rules that took effect in 2010 made it an ideal time to consider converting a 401(k) or traditional IRA balance to a Roth IRA. The Small Business Jobs and Credit Act that President Obama signed into law yesterday will make it even easier for active participants in 401(k) plans to take advantage of the tax-free growth that a Roth account provides.

Under the law companies are allowed, but not required, to amend their 401(k) plans immediately to allow participants to roll over exsting 401(k) plan balances into in-plan Roth accounts. Funds rolled into the Roth 401(k) plan account would earn tax-free investment income. Unlike withdrawals from traditional 401(k) accounts that are taxed at the individual's regular income tax level, distributions from a Roth 401(k) account are not taxed.

Of course, the rollover to the Roth 401(k) account is considered a taxable event. Consistent with the conversion rules for Roth IRAs, the tax on any rollovers to a Roth 401(k) plan account during 2010 can be deferred and spread over the next two years. The law also provides for participants in Section 457(b) defined contribution plans to be able to make Roth contributions beginning next year.

Just like with Roth IRA conversions, whether or not it makes sense for participants to roll over their 401(k) balances to a Roth 401(k) depends on their current and projected future tax brackets. Participants unsure about their future tax rates may want to roll some money into a Roth 401(k) but keep the rest in a traditional 401(k) plan.

Individuals already had the option of rolling 401(k) balances into Roth IRAs so what benefit does the new law provide? Since the rollover can now occur within the plan, it makes converting a traditional 401(k) balance to a Roth account more convenient. More importantly, the fees on funds offered by an employer-sponsored 401(k) plan are usually less than those charged by funds offering Roth IRAs. Thus, the law provides a simple and more cost-effective way for participants in a 401(k) plan to enjoy the benefits of a Roth investment account.

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