In the past, it took two steps to transfer funds from a 401(k) plan to a Roth IRA, thereby effecting a Roth conversion contribution.
The plan participant had to use a traditional IRA as a go-between. And certain high-income taxpayers couldn’t complete the deal in any event. But the rules have changed for the better.
Strategy: Use a one-step rollover. When it’s appropriate, roll over funds directly from a 401(k) or other qualified plan account into a Roth. You don’t have to do the two-step dance anymore.
Best of all, there’s no longer any restriction based on your income, beginning in 2010. This change is expected to spur even more direct rollovers this year.
Accordingly, the IRS has issued guidance on 401(k)-to-Roth rollovers (IRS Notice 2009-75), which clarifies previous explanations provided in IRS Notice 2008-30 (see box below).
Here’s the whole story: A participant’s 401(k) account, which may consist of both pretax employee deferrals and employer contributions, grows without any current tax. The plan might also allow after-tax contributions. However, the taxable part of any distribution (often 100%) is taxed at ordinary income rates, currently reaching as high as 35%.
In contrast, Roth IRA contributions are made with after-tax contributions, but there’s no current tax on earnings. Furthermore, “qualified distributions” from a Roth are completely exempt from federal income tax. A qualified distribution is one made after reaching age 59½, on account of death or disability, or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). Note that qualified distributions can occur only after the account owner has had at least one Roth account open for at least five years.
Prior to the Pension Protection Act of 2006 (PPA), a 401(k) participant wanting to transfer assets to a Roth had to roll over the funds to a traditional IRA first. Then he or she converted the traditional IRA into a Roth and paid the resulting tax liability and the rollover couldn’t be completed in a year in which his or her modified adjusted gross income (MAGI) exceeded $100,000.
New rules: The PPA simplifies the two-step conversion process by allowing 401(k) plan participants to roll over funds directly to a Roth, bypassing the traditional IRA. This change applies to distributions after Dec. 31, 2007. But taxpayers were still hampered by the MAGI limit on conversions in 2008 and 2009.
Not anymore. Effective Jan. 1, 2010, the $100,000 cap on conversions is history. Tax bonus: For a conversion taking place in 2010, you can spread out the resulting taxable income evenly over the following two years—50% in 2011 and 50% in 2012.
Here are a few other key points established under IRS Notice 2008-30:
- Distributions may be rolled over to a Roth IRA from a variety of eligible retirement plans, including 401(k), 403(b) and 457(b) plans. The plan must permit employees to elect direct rollovers to a Roth IRA.
- A direct rollover to a Roth IRA is not subject to automatic 20% federal income tax withholding. However, an employee and employer can choose to enter into a voluntary withholding agreement.
- Beneficiaries can make qualified rollover contributions to Roth IRAs. Also, a surviving spouse who completes a rollover to a Roth IRA may treat the Roth IRA as his or her own. However, this treatment is not available to nonspouse beneficiaries.
- Under the PPA, a plan must provide a participant with the opportunity to elect a qualified optional survivor annuity if the qualified joint and survivor annuity is waived.
- Defined generally allow a retiring participant to elect to receive a lump-sum distribution in lieu of lifetime annuity payments. The lump-sum payment must be at least equivalent to the present value of the life annuity based on the applicable mortality table.
Tip: Regular annual Roth IRA contributions (as opposed to conversion contributions) are still off-limits to certain high-income taxpayers.
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