This article was last updated on February 5
With a deal to avert the fiscal cliff reached and legislated under the American Taxpayer Relief Act (ATRA) of 2012, a couple of significant employer sponsored retirement plan features have reappeared with some modifications. You can read this article for an overview of the main 2013 income tax related changes in the ATRA act, but in terms of retirement planning the reinstatement and updates to some of these past provisions will have some considerable (and potentially positive) impacts.
Traditional 401(k) conversion to a Roth 401(k)
The updated 2013 provision to allow a re-characterization or conversion of funds from a traditional 401(k) into a Roth 401(k) was allowed by the government in order to raise revenue to offset delays with government sequestration/spending cuts. By choosing to convert pre-tax 401(k) retirement savings to a Roth 401(k) an employee would pay taxes at the time of conversion, but any future earnings or withdrawals within the Roth 401(k) account would be tax free at retirement. This conversion option is not new and was previously allowed (in 2010, under the small business jobs act) for 401(k) account holders with so-called “distributable” funds, a relatively small group that mainly included people 59 1/2 and older. Under the new fiscal cliff/ATRA legislation rules, a Roth conversion would be available to anyone with a traditional 401(k) and an employer who offers a Roth account conversion option.
A Roth 401(k) works similar to the better known Roth IRA, except that like a traditional 401(k) plan it allows higher contribution limits. A Roth 401(k) though has to be administered by your employer and you are limited to the investment choices your employers retirement plan provides. Conversions to a Roth 401(k) works best for people in lower tax brackets who have extra cash on hand or those anticipating making a significantly higher income in the future and so would be subject to potentially higher taxes on their 401(k) income in retirement. Roth 401(k)’s are also an effective estate planning tool because you are essentially prepaying the tax liability on retirement funds that you are leaving to your benefactors and/or heirs.
The new legislation will prompt many employers to include the 401(k) conversion feature to their retirement plans as an added employee benefit. And given the fact that employees can convert all their 401(k) holdings (there is no conversion limit) to a Roth 401(k) the take-up of this option may be higher than expected.
The new conversion rules apply not just to 401(k) plans, but also to other pre-tax retirement plans like 403(b)s, thrift saving plans and 457 (b) plans. The new rules are already effective and you can transfer amounts contributed to pre-tax accounts in 2012 and earlier. This includes all employer matching contributions. Future contributions can be made directly to the Roth 401(k) account.
Charitable IRA contributions
The IRA Charitable rollover has also been resurrected for calendar years 2012-2013 as part of the fiscal cliff deal. The provision last expired at the end of 2011, but was extended to the end of 2013. The charitable rollover allows people 70½ and older to transfer as much as $100,000 per year from their traditional IRAs to a charity of their choosing. The donation counts against the annual minimum required distribution so is a good option for those seeking to help a good cause with their excess retirement funds. To execute this transaction though you must work through the custodian of your IRA account (e.g. Vanguard or Fidelity) to send the IRA contribution certain to the charity, rather than directly withdrawing and donating it yourself.
Higher 2013 Roth IRA limits
While not part of the fiscal cliff deal many should consider bumping up their or their partners Roth IRA contributions to benefit from the higher contribution limits for 2013. If you meet income and other eligibility rules you can contribute $5,500 to a Roth IRA account, vs $5,000 in 2012. If you are over 50 you can add an additional $1,000 catch-up contribution. You can find a list of good Roth IRA brokers here.