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For those who haven't heard, investors in 401(k) and other defined contribution plans can now convert their assets to a designated Roth account within the same plan, provided the employer offers the option.
The "fiscal cliff" legislation passed by Congress in 2012 expanded an earlier law that allowed such conversions, but only for employees who were eligible to take a distribution from their plan funds. The earlier essentially limited it to workers who had either left the company or who were older than 59½. That meant that virtually anyone who qualified for the in-plan conversion under the earlier law also was eligible to convert their 401(k) to an ordinary Roth IRA, essentially neutralizing the effect of the law.
As of January 1, 2013, provisions in the American Taxpayer Relief Act of 2012 allow any amounts in defined contribution plans, such as 401(k) plans, 403(b) plans, and governmental 457(b) plans, to be converted into a designated Roth account within the same plan, regardless of whether the employee is eligible to take a distribution from the plan.
That doesn't mean that all employees suddenly have access to in-plan Roth conversions. Many employer plans don't offer Roth components. And not all plans with Roth options allow in-plan conversions. The law left it to the discretion of the plan sponsor.
There are some important things to know about in-plan Roth conversions:
Glossary of Terms
401(k) plan—A 401(k) is a qualified plan established by employers to which eligible employees may contribute a portion of their salaries on a pretax or Roth aftertax basis, through individual payroll contributions. Earnings accrue on a tax-deferred basis.
403(b) plan—A 403(b) offers all the pretax and Roth aftertax payroll investment features of a 401(k) plan to most nonprofit organizations, typically schools and charities. Generally, if the program offers payroll contributions only, it is called a "non-ERISA" 403(b) arrangement. If there are employer contributions, it is called an ERISA 403(b).
457(b) plan—A 457(b) is a nonqualified, deferred-compensation plan established by state and local governments, tax-exempt governments, and tax-exempt employers. Eligible employees are allowed to make salary deferral contributions to the 457(b) plan. Earnings grow on a tax-deferred basis and contributions are not taxed until the assets are distributed from the plan.
Traditional IRA—A tax-deferred savings plan available to all working individuals under age 70 and their spouses, if the spouse also is under age 70. It is set up for the exclusive benefit of an individual, although the proceeds may ultimately go to a beneficiary(ies).Contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.
Roth IRA— tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.
Please note that there may be administrative fees and other costs involved in an IRA rollover and conversion to a Roth IRA. The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is being provided for educational and informational purposes only and is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with their appropriate tax, legal and financial advisor with respect to individual circumstance and all applicable federal, state and local tax laws.