Recent tax law changes have opened up a whole new area of tax planning around employee retirement plans. Individuals with IRA accounts always have had the opportunity to do a Roth conversion, but now for the first time an employee’s 401(k) account also may be converted. Because a 401(k) typically will have a much larger balance than an IRA, this tax opportunity deserves serious consideration, particularly for individuals who currently are in the Alternative Minimum Tax.

Background

This past September the Small Business Jobs Act of 2010 was signed into law. One of the provisions in this act allowed, for the first time, a "regular" 401(k) to be converted to a Roth 401(k). The sponsoring employer first must make the appropriate plan amendments to allow this, but because of the popularity of this provision it is estimated that over half of all employers already have made this change.

What happens upon conversion?

The dollars an employee contributes to a regular 401(k) are pre-tax. What this means is that income taxes have not yet been paid on these contributions; instead, when distributions are taken from the plan, typically at retirement, taxes are paid at that point. Along with the original contributions, the investment earnings in the 401(k) likewise are taxable when withdrawn. In contrast, a Roth is funded with after-tax dollars, so, correspondingly, there are no taxes due at the time the funds are withdrawn. Similarly, the earnings on these funds are not taxed at distribution.

At the time of conversion from a regular 401(k) to a Roth, income taxes must be paid on the full amount converted. With this prepayment of taxes, and the 401(k) now officially a Roth, no taxes are due when distributions are made.

Example

Assume over the years you have put $100,000 into your regular 401(k), and the cumulative investment earnings are $50,000. If you did a Roth conversion today, assuming you are in the 33% Federal bracket (Regular Tax; not the AMT), along with a state tax rate of 6%, you would pay $58,500 in taxes, leaving $91,500 for your retirement spending.

Compare this to an account that was a Roth 401(k) right from the start. Since you would have paid the 33% and 6% taxes before the monies went into the account, you would have contributed only $61,000 ($100,000 less $39,000 in taxes). Earnings on this at the same rate of growth as in the example above would have been $30,500, for a grand total in the account of $91,500.

The point

As was seen in the example above, there is one single most critical point in making a Roth conversion analysis: the comparison between the taxpayer’s current tax bracket and the tax bracket he or she expects to be in at retirement. How does one go about making this comparison?

Tax brackets – assuming no changes

On the IRS web site one can see that, assuming married filing jointly status, the Regular Tax 28% bracket is reached at $83,600 of taxable income, the 33% bracket at $174,400, and the 35% bracket at $379,150. Compare this to the AMT bracket of 26% for Alternative Minimum Taxable Income up to $175K, and 28% for everything over that level. Ignoring for purposes of simplicity the fact that taxable income is not computed the same for the AMT as it is for the Regular Tax, looking at these brackets reveals something very interesting: AMT brackets are significantly lower at roughly comparable levels of income.

This fact alone is the reason individuals currently in the AMT definitely need to give serious consideration to doing a Roth conversion. The potential for a 7% savings from differences in the tax brackets (28% vs. 35%, e.g.), or even more, definitely is there.

Tax brackets – there will be change

Making things a little more difficult, however, is the fact that tax brackets will change. Someday the Democrats will get their way and the Bush tax cuts will be allowed to expire. When this happens, Regular Tax rates will increase, and it will appear even more attractive to do a Roth conversion today. Keep in mind, however, that one of the other likely changes in tax brackets simply will be the individual taxpayer’s level of income. For most folks, income in retirement will be less than what it is while they are working, and, thus, that person’s tax bracket will decrease. To what extent this will or will not offset the anticipated increase in the brackets from the law changing is up to each individual to decide.

Conclusion

The recent change in the tax law allowing Roth conversions presents every individual with a 401(k) a real opportunity to save taxes. This opportunity is much greater for taxpayers who currently are paying the Alternative Minimum Tax than it is for those who are not. A little time spent making a Roth conversion analysis easily could result in thousands of dollars in tax savings.