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Tax Cliff Deal Allows Everyone to Convert a 401(K) to a Roth 401(K)

Tax Cliff Deal Allows Everyone to Convert a 401(K) to a Roth 401(K)

The fiscal cliff tax deal worked out by Republicans and Democrats in Washington has a big benefit for anyone who has a traditional 401 (K) account. A traditional 401(K) allows for pre-tax contributions, meaning money place into the account isn't taxed. This allows for more of your money to be saved and lowers your current tax bill when you're working.

With current savings account rates so low right now any strategy you can use to maximize your earns is a step you would take.The best savings rates right now are at 1.00 percent which won't give you much of a return when you're close to retirement and need to lighten up on equity holdings by placing retirement funds in a savings account or mutual fund.

Money placed in the account and any gains can be taken out penalty-free after age 59 1/2 but you do have to pay taxes on the money withdrawn. If you take money out before age 59 1/2 you pay taxes and a 10 percent penalty. With a Roth 401 (K) money placed into the account has already been taxed and money taken out isn't taxed, that includes any gains in the account.

The in-plan Roth conversion was only possible for money that was distributable. Back in 2010 a law was passed that allowed anyone with money in a traditional 401(k) that was distribuable which means anyone 59 1/2 or older could convert to a Roth 401 (K). Now everyone can convert to a Roth 401(k).

The new conversion rules are effective as of the first day of 2012 but you can only transfer amounts contributed to pre-tax 401(k) accounts in 2012 and before. You can convert you're entire 401(k) account and elect to make new contributions directly to the Roth 401(K) account. You will lose the tax benefit for future elections so you can also just make new contributions to a traditional 401(k) account but future withdrawals will be taxable.

Whether or not you should convert depends on your situation and if you believe tomorrow's tax rates will be higher than where rates are right now. You can apply the same strategies that you would when converting a traditional pre-tax IRA to a Roth IRA. You pay income tax on the amount you convert today and the Roth 401(k) grows tax free and eventual distributions are tax free in the future.

Author: James Martin
January 9th, 2013