Fiscal Cliff Aftermath: New Option for 401(k) Savers

To raise revenue, lawmakers unlocked $12 billion in taxes owed by easing the rules on when you can convert traditional 401(k) assets to Roth 401(k) assets.

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In an effort to unlock tax revenue, not just raise rates on the wealthy, architects of the fiscal cliff deal handed certain retirement savers a small bonus: You can now convert traditional 401(k) plan assets into a Roth 401(k) regardless of age and employment status.

Under the old rules, to convert you typically had to leave your job, retire, become disabled, or reach age 59½ and be eligible for normal distributions. So this is welcome flexibility, though it won’t be available to everybody. Only 40% of employers offer a Roth 401(k) in the first place, and not all of those plans allow conversions. But at those that do, there is now nothing to stop you from making the switch.

(MORE: How to Make the Most of Your 401(k) in 2013)

Whether you should is another matter. Roth 401(k) contributions are made after tax; they grow tax-free. Traditional 401(k) contributions are made pre-tax; they are taxed upon withdrawal. In general, you need to believe you’ll be in a higher tax bracket in retirement for the conversion to make sense. You also need enough other funds to pay the potentially sizable one-time tax bill that comes due when you convert.

This switch works a lot like a conversion outside your 401(k)—from a traditional IRA to a Roth IRA. And the thinking for doing so is much the same. Likely candidates are young workers in a low tax bracket who can benefit from decades of tax-free growth. Another likely candidate is anyone who has suffered a temporary income lull, and can take a large distribution without being shoved into a higher tax bracket. A conversion might also make sense if you convert smaller amounts each year in order to afford the tax and not be pushed into a higher bracket.

One important difference with this conversion is that it cannot be reversed. Outside your 401(k) plan, assets converted to a Roth account can be “recharacterized” later in the year and shifted back to a traditional IRA if you change your mind. This is a valuable feature because if you convert, say, $1 million and your portfolio suddenly slumps to $500,000 you would still owe tax on the $1 million—unless you recharacterize. But you cannot do that with a 401(k) Roth conversion. There, all sales are final.

(MORE: Lots of Goodies Were Stuffed into Fiscal Cliff Deal)

Financial planners doubt there will be a rush to convert traditional 401(k) assets to Roth 401(k) assets. Still, lawmakers expect enough interest in the conversion to unlock $12.2 billion in tax revenue over the next decade. That near-term revenue is what drove the change, handing savers an extra layer of flexibility.