Roth in-plan conversion

Weak equity markets have one silver lining for 401k plan participants with large account balances: a Roth in-plan conversion.


The Roth In-Plan Conversion Option



What is a Roth in-plan conversion?


A Roth in-plan conversion option is a unique tax planning tool. Roth 401k accounts are the only investments I can think of where the investor has control over when an investment is taxed — without actually having to liquidate it.

Normally, taxation on an investment is triggered when it is sold, not re-characterized into a different account or form. A Roth in-plan conversion turns pre-tax 401k account balances into Roth after-tax account balances. State and federal taxes are due on amounts converted.


Why now?


Most of us have experienced significant declines in the value of our 401k account balances as a result of weak equity markets. These losses may have been even greater for participants who had a well-diversified 401k account with a heavy allocation to equities and exposure to commodities. These individuals may have unrealized losses in their accounts of as much as 20% or 30%.

Converting pre-tax 401k balances into after-tax Roth 401k balances results in taxation of the previously untaxed 401k balances. Converting when the account value is lower may result in substantial tax savings. Here is an example.


Example of Roth in-plan conversion


Let’s assume a participant has a $1 million account balance and is interested in converting 20% of it into a Roth 401k account. Prior to the recent decline in market value, assume the existing $200,000 slice of this account was worth $300,000. In other words, assume the participant has experienced a 33% decline in the value of the account.

Taxes are due on amounts converted into Roth 401k accounts. So the participant would owe state and federal taxes on the $200,000 portion of the account balance that is converted.

However, the participant would save paying taxes on $100,000, which is the difference between the previous value of $300,000 and the current value of $200,000. In this example, a participant subject to a combined 30% state and federal tax rate would save $30,000 in taxes right now. But the overall tax savings related to the conversion could turn out to be much, much greater.

Roth 401k account balances residing in accounts for five or more years and withdrawn for permissible reasons are not subject to any state or federal taxes when distributed.

We know the markets will bounce back. Assuming this participant experiences a reasonable rate of return over the next 10 years, the tax savings could be massive on the $200,000 that was converted plus 10 years of earnings. This amount could be withdrawn completely tax-free!


Reasons to Offer Roth Accounts and a Roth In-Plan Conversion Option


Your 401k plan may not currently offer Roth 401k accounts or a Roth in-plan conversion option. If it doesn’t, consider the reasons below to amend your plan soon to offer them.


Low cost


With such a powerful tool available (where else can you choose when to have an investment taxed without having to sell it?), the cost to implement this plan change must be enormous, right? Not so.

You will need to amend your 401k plan to add the feature and then communicate the change to participants. Depending upon your plan’s size, that might mean the total cost of a plan amendment and communication materials falls somewhere around $2,500.


Strategic


I believe that every 401k plan participant should establish a Roth 401k account. Why? If for no other reason than to get the five-year clock started. Remember, a Roth account has to be in existence for five years before amounts may be withdrawn tax-free.

However, every dollar does not need to be in a Roth account for exactly five years to receive the tax-free benefits. All it takes is the first Roth 401k contribution to get the clock started. All future Roth 401k contributions, whether they have been in the account for five years or not, will benefit from preferred tax treatment upon withdrawal.

Even if participants don’t believe that tax rates will be higher in the future, why not start the Roth five-year clock ticking anyway? It costs next to nothing (put $10 in it!) and they have very little to lose.


Huge benefit to young workers


It would seem that employees just starting their careers might benefit greatly from using Roth 401k plan accounts. Since they have 30 or 40 years to work, just think of the tax-free balances they could accumulate over their careers.

Even participants who are cynical and believe the government will change its mind and begin to tax these balances if they get too large, should start to fill a Roth bucket up anyway. There is always the possibility that certain amounts would be grandfathered.


What you should do


Over the course of their career, participants may have the opportunity to use a Roth in-plan conversion many times. In order for your 401k plan to permit such exchanges, it needs to allow for Roth 401k accounts and Roth in-plan conversions. If your plan isn’t structured this way, you will need to amend it.

Survey data indicate nearly 70% of all companies permit Roth 401k contributions, but less than 20% of employees actually contribute to them. More employee education around the benefits of using Roth 401k accounts is needed. Make sure you include Roth 401k account education in your annual employee education sessions.

There appears to be no downside associated with adding Roth accounts and a Roth in-plan conversion feature. It will likely cost little or nothing additional to administer each year and is a nice option to offer employees.

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About the Author

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in Socially Responsible Investment (SRI) strategies for retirement plans and is a pioneer in the field. LRPC currently has contracts in place to provide consulting services on nearly a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, a plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.