Roth retirement accounts make sense under the new rules

A little-noticed feature of a new federal law will give a dramatic boost to the popularity of Roth accounts in workplace retirement plans.

The Small Business Jobs Act that President Obama signed late last month really has very little to do with retirement saving. Its main purpose is to stimulate the economy via $12 billion in tax cuts and credits to small businesses. But lawmakers wanted to offset those costs, so the law also includes a revenue-raising provision that vastly expands the opportunity to convert tax-sheltered retirement savings to Roth accounts.

Unlike tax-deferred accounts, retirement savers use Roths to avoid taxes on investment income down the road by paying income taxes upfront. That can be done by starting a fresh Roth account, or by converting funds from a tax-sheltered account to a Roth. The converted dollars count as taxable income in the year of conversion.

Some employers have been offering a Roth option within their workplace plans for the past few years, but conversions could be done only with Roth IRAs outside the workplace.

The jobs act includes a provision that permits investors to convert tax-sheltered funds to Roth accounts within a 401(k) plan, if the employer offers that option.

Previously, conversions could be made only with Roth IRAs, and people younger than age 59½ generally could do it only when leaving a job. The new conversion rule lets anyone make a conversion within a 401(k) plan, regardless of age. The jobs act also permits creation of Roth accounts in state and local government 457(b) plans, starting in 2011. The retirement-related provisions of the bill are projected to raise $6.6 billion in new income tax revenue between 2011 and 2020.

"This law makes tens of millions of people, in essence, eligible for conversion without having to quit their job to do it," says Dallas Salisbury, president of the Employee Benefit Research Institute. (All limits on income eligibility to do Roth conversions were removed this year under separate legislation.)

The new 401(k) conversion rule comes at a time when Roths are starting to take off in employer-sponsored plans.

Roth IRAs have been around since 1998. But companies didn't start offering Roth 401(k)s until Congress eliminated sunset provisions on the accounts via the Pension Protection Act of 2006.

A study by Hewitt Associates, the employee benefits consultants, found that 29 percent of mid-size and large employers now offer a Roth option in their retirement plans, and many more plan to add them.

"Workplace Roths will become standard over the next few years," says Pam Hess, director of retirement research at Hewitt. "About half of plans will have them by end of 2011, and it will continue to grow from there."

A Roth inside a 401(k) plan offers two compelling advantages over a Roth IRA:

You can contribute more. The annual limit on a Roth IRA is $5,000, but a workplace Roth is governed by the 401(k) ceiling rules - this year, it's $16,500. What's more, a Roth 401(k) allows you to max out your contribution and pay taxes with additional dollars - it's a more "pure" form of retirement saving.

You can capture a match. The workplace Roth can be used to generate any matching contribution that might be available from your employer - although any matching contributions must go into a tax-deferred account.

Roths are favorable for young workers with lower incomes. "If you're still in a 10 or 15 percent tax bracket, it's a good time to use a Roth, as opposed to your 40s or 50s, when you may have pushed yourself up the tax scale," Salisbury says.

Hewitt found the highest rate of workplace Roth adoption (16.6 percent) among workers age 20-29. The study also showed that workers contributing to Roths had higher total contribution rates - 10.8 percent of salary compared with 8.1 percent of workers using only tax-deferred accounts.

When will you be able to take advantage of 401(k) Roth conversions? The new rules became effective immediately, which means workplace savers could do conversions this year - in theory. But much will depend on how quickly employers move to amend their plans, so the action probably will start to heat up in 2011.

If you do a conversion in 2010, the law allows you to spread your income tax liability to your 2011 and 2012 tax returns if you prefer. That's a one-time option that Congress provided earlier, when it lifted the income limits on conversions.

One additional note: The new jobs act conversion provision is a great example of how Washington works (or doesn't work) these days. It's expected to bring in revenue in the near term, but likely will cost the U.S. Treasury later.

"It's a bit of a gimmick," explains Kayde Thomas, a tax attorney and author of several books on taxes and investing. "People generally use a Roth when they think it will produce more tax savings overall - you're putting money in now because you're looking at 20 or 25 years of tax-free investment earnings, and you're willing to pay the tax now to eliminate a tax bill later."

Salisbury adds: "It's the equivalent of being happy you balanced your budget this year by putting money on your credit card."

Mark Miller's Retire Smart column

is carried on Tribune Media Services.