Which Clients Are Suited for Roth Conversions?

“A lot of retirement plan participants don’t even know what a Roth account is, and many that do wish they had known sooner,” says Meghan Murphy, director of thought leadership at Fidelity Investments in Boston.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) introduced Roth accounts to defined contribution plans. The accounts allow plan participants to contribute after-tax money to their savings on which they will owe no taxes on qualified distributions. The provision of Roth accounts was set to end in 2010, but the Pension Protection Act (PPA) in 2006 made the accounts permanent.

The Internal Revenue Service (IRS) issued guidance in 2010 allowing for participants to do an in-plan rollover, called conversions, of pre-tax accounts to Roth accounts upon a distributable event. But, in 2012, it expanded that ability to non-distributable amounts.

Tim Steffen, director of Financial Planning at Robert W. Baird & Co. in Milwaukee, tells PLANADVISER the primary reason a retirement plan participant would want to convert pre-tax money to a Roth account is that the tax cost on the amount converted today would be less than the tax cost of distributions from pre-tax accounts later. “Participants must compare the tax benefit during the contribution period to that of the distribution period,” he says.

For example, a high-income individual may decide tax-deferral during his peak earning years is more valuable than paying no tax on distributions during retirement when he will be in a lower tax bracket, Steffen explains. On the other hand, Baird tells younger participants who are entering the workforce and in their lowest earning years, they would probably get a better value by putting retirement savings into a Roth account.

Murphy adds that Fidelity sees younger people doing Roth conversions because they realize they have 30 or more years until retirement and see it as a great opportunity to not have to pay taxes in the future.

NEXT: Rules about Roth conversions

Lisa H. Barton, a partner with law firm Morgan, Lewis & Bockius LLP in Philadelphia, Pennsylvania, notes that, in order for a DC plan participant to initiate a Roth conversion, the plan document must allow for that. She tells PLANADVISER, the plan document will specify what amounts can be converted; the plan can permit amounts in pre-tax, match, after-tax and/or profit sharing accounts to be converted.

Even if an account that is already made up from after-tax contributions is converted, the earnings in those accounts that are converted would not be taxable, so there is a tax benefit for every type of account, Barton points out.

Participants can only convert amounts in which they are fully vested. And, the plan document will specify how often participants are allowed to initiate a conversion.

According to Barton, taxes cannot be taken out at the time of the conversion. Steffen explains this is because that would make the converted amount an early withdrawal, subject to a penalty. Murphy adds that the recordkeeper provides a statement to participants at year end and they report the converted amount as income with their annual return. Fidelity always tells participants who want to initiate a conversion that they should consult with a tax adviser before making a move that would impact income taxes.

When offering the ability to do Roth conversions, plan sponsors should consider what their recordkeeper can handle and what the recordkeeper requires, Barton says. “It gets tricky from a recordkeeping perspective.”

She explains that whatever withdrawal provisions apply to amounts before conversion have to apply after conversion—if a withdrawal type wasn’t available for the amounts before, it cannot be afterward, and vice versa—except for hardship withdrawals. In addition, amounts converted must be held in the account for five years starting at the date of conversion before they can be distributed or they will be subject to a pre-tax penalty. These two conditions create the possibility of the recordkeeper having to keep up with several different buckets of money.

Finally, Barton says, participants are not required to get spousal consent to do an in-plan conversion. If a converted account has an outstanding loan, it is treated the same in the Roth account. If the plan is a safe harbor plan, it cannot be amended to add a Roth conversion provision mid-year.

NEXT: What participants need to know

According to Murphy, Roth conversion ability is so much more common among large plans; 1,800 of Fidelity’s clients offer the option. “Normally the option to convert to Roth is being added to the plan because participants are telling plan sponsors they want it, yet a small percentage of participants use the option,” she says.

“There is a big need to educate participants about Roths,” Murphy says. “They already have two choices—how much to save and how to invest—and now they must make a decision about the tax treatment of their contributions. Most people don’t even know what tax bracket they are in.”

She suggests plan sponsors educate participants when the feature is adopted for the plan, upon hire, and during open enrollment. Roth education should also be part of information available to participants through advice programs, and if the plan has an adviser, sponsors should make sure advisers are educating participants.

Participants need to understand whether contributing to or converting to a Roth account is right for them. For participants who are underprepared for retirement or plan to rely mostly on Social Security in retirement, Roth may not be right for them, Murphy explains. And, highly compensated participants who will return to a lower tax bracket in retirement should not convert to a Roth.

Also, Murphy says, participants who have tax concerns already should consider whether they are prepared to add to their tax bill now. Participants need to understand that there is a tax-cost, Steffen adds. He says sometimes they do a large conversion and are taken aback by how much taxes are. He notes that one of the things participant education should highlight is that they don’t have to convert an entire account balance at once; they can do smaller pieces each year.

There are reasons other than tax treatment that participants may consider converting amounts to Roth accounts. Steffen notes that they can avoid having to take a required minimum distribution (RMD) on some of their savings; while money in a qualified retirement plan is subject to RMDs, participants can roll those accounts to a Roth individual retirement account (IRA) upon retirement which is not subject to RMDs.

The allowance of conversions of after-tax amounts to a Roth account may help people put away more money for retirement in Roth accounts. Barton explains that after-tax contributions are not subject to the IRS 402(g) limit on deferrals, but they still are subject to non-discrimination testing, so this may not help some participants put away more savings.

“The decision to contribute to or convert to Roth accounts is really specific to each individual,” she concludes.