Fiscal Cliff Deal and Backdoor Roth

Backdoor

Happy New Year!

News came that Congress passed a fiscal cliff deal, official known as the American Taxpayer Relief Act of 2012. Whether you like it or not, that’ll be the law for now. Rather than doing a run-down for what’s in it, which I’m sure you read everywhere, I will look at one item at a time.

Section 902 of this new law added a provision about converting retirement assets from Traditional to Roth. That got some people worried about the potential effect on the backdoor Roth.

Here’s the text in the new law. I highlighted the pertinent parts:

SEC. 902. AMOUNTS IN APPLICABLE RETIREMENT PLANS MAY BE TRANSFERRED TO DESIGNATED ROTH ACCOUNTS WITHOUT DISTRIBUTION.

    (a) In General- Section 402A(c)(4) is amended by adding at the end the following:
        ‘(E) SPECIAL RULE FOR CERTAIN TRANSFERS- In the case of an applicable retirement plan which includes a qualified Roth contribution program
          ‘(i) the plan may allow an individual to elect to have the plan transfer any amount not otherwise distributable under the plan to a designated Roth account maintained for the benefit of the individual,
          ‘(ii) such transfer shall be treated as a distribution to which this paragraph applies which was contributed in a qualified rollover contribution (within the meaning of section 408A(e)) to such account, and
          ‘(iii) the plan shall not be treated as violating the provisions of section 401(k)(2)(B)(i), 403(b)(7)(A)(i), 403(b)(11), or 457(d)(1)(A), or of section 8433 of title 5, United States Code, solely by reason of such transfer.’.
    (b) Effective Date- The amendment made by this section shall apply to transfers after December 31, 2012, in taxable years ending after such date.

This new rule allows more people to convert money in their traditional 401k, 403b, or 457 plans to Roth 401k, 403b, or 457. Doing so is called an "in-plan Roth rollover." Before this new rule, it is allowed only if the participant is already eligible for a distribution (over 59-1/2, terminated from employment, etc.), which makes it practically useless because you might just as well rollover to a Roth IRA instead of doing it within the plan.

This new rule extends the eligibility to everyone, not just those over 59-1/2, terminated, etc. Of course the plan still has to allow it. You can only do it within the plan. Getting the money out to a Roth IRA while under 59-1/2 and still working for the employer remains off limit.

Now that the law allows in-plan Roth rollovers for more people, whether it’s a good idea to do so is still a different question. I can only think of very limited scenarios where an in-plan Roth rollover can help but rolling over to a Roth IRA isn’t an option. An employee can do the in-plan Roth rollover after his/her spouse quit to go to graduate school (temporarily lower income); previously only the spouse who quit can do it. Or maybe someone in a plan that allows after-tax (non-Roth) contributions but doesn’t allow in-service withdrawals can do an in-plan Roth rollover on the after-tax contributions now.

Anyway, this new rule does not deal with converting from a Traditional IRA to a Roth IRA. It affects only converting to Roth 401k/403b/457 within the same plan. It has no effect on the backdoor Roth.

[Photo credit: Flickr user arkh4m]

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Comments

  1. JimInIllinois says

    One thing this does is allow those of us in states that don’t tax retirement distributions to reduce our state-taxable income by deferring into a 401k, and convert an equal (or otherwise) amount to Roth, paying only Federal taxes on the converted amount. That takes away one of the arguments against the Roth 401k.

  2. Harry says

    Good point. It means you still shouldn’t contribute to the Roth 401k directly, similar to what happens in deduct and convert. If you do indirectly — Traditional 401k first, followed by an in-plan Roth rollover, you don’t pay IL state income tax. If you contribute to the Roth 401k directly, you pay IL tax.

  3. Peter says

    Hi,

    Thanks for clarifying this issue. The WSJ and others misreported and claimed that this would allow 401(k) to Roth IRA conversions.

    One question about the point made above by Jim. Is there a list of states that don’t tax retirement distributions? I live in Massachusetts and want to know if it makes more sense for me to contribute to a Traditional 401(k) and then convert to the Roth 401(k). Also, is there a limit to the number of times in a year you can convert from Traditional to Roth?

    Thanks again.

  4. Harry says

    Peter – The deduct and convert article has the list of states. Although that article was about doing it for IRAs, it also applies to in-plan Roth rollovers, only better because you don’t have to deal with the income limit on deducting your IRA contributions. The law doesn’t impose any limit. Your plan may impose an administrative limit.

  5. Joe says

    The debate surrounding the logic of a roth conversion is ludicrous. For starters, assuming the same rate of return inside the two vehicles and also assuming tax rates do not change from the time of conversion until retirement, the net dollars into a savers’ account at the time funds are withdrawn are virtually the same. For seconds, if you are a boomer who will be retiring between say between 2018 and 2025 it is an obvious odds-on bet that income tax rates will go up over the next 10-15 years as the Progressives continue to press their agenda. The rates will go up for everyone, not just the so-called rich.

    The bottom line is the same money net to the retirement investor, but the 401K remains open to massive policy risk.

    By converting existing 401K funds now an investor is able to accomplish one primary goal that should always be in the forefront of one’s mind: The management of risk – in this case the risk of massive and fundamental tax policy changes by a government that is even now clearly in extremis.

    Those who assume a change to a value added tax would be accompanied by the elimination of the Federal income tax, thereby magically creating an escape from income taxes levied on funds earned in prior years and upon which tax had been deferred in a 401K, are holding a very thin reed. Frankly, such an argument is beyond ridiculous. Almost certainly an excise tax would be charged on withdrawals of tax deferred funds at the very least.

    As well, the argument made by many that the government “will just come after the roths too” is profoundly stupid, considering such a move would immediately wind up in what would be a very short-lived litigation. And if such was not the case then the reality at that moment in time would be that we would be living in a country that has abandoned the rule of law and NO assets will be safe from unlawful seizure by a socialistic government bent on the destruction of private property rights.

  6. susan says

    If you have a non deductible ira with little or no tax liability that you convert to a ROTH will you now have to convert an equal proportion from a 401 K with much higher tax liability. Thank you

  7. Chucks says

    Can this be used to convert employer 401k contributions to Roth contributions if the plan so permits? I’m probably reading this too broadly.

  8. Harry says

    Chucks – Yes, vested employer contributions and earnings can also be rolled over within the plan as Roth after the plan is amended to allow such in-plan rollovers as permitted by this new law.

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