Alittle-noticed provision of the big New Year's tax deal could have significant impact on some of your clients. New rules for in-plan Roth 401(k) conversions have opened up some interesting new planning possibilities - and although the conversions come with a few pitfalls, some clients will find them to be a valuable option.

In-plan Roth conversions were first introduced into law back in 2010, as part of the Small Business Jobs Act. The idea was to allow plan participants an opportunity to move money from the traditional side of their company plan, such as a 401(k), to a Roth 401(k) within the plan. Plans that can offer a Roth option include 401(k), 403(b) and governmental 457(b) plans. (The federal government's thrift savings plan also offers a Roth option.)

When that act was introduced, the rules did not allow clients to make an in-plan Roth conversion unless they were eligible to take a distribution of their plan funds - for the most part, restricting it to workers who had either left the company or were older than 591/2. In essence, this meant that nearly every client eligible to make an in-plan Roth conversion could also make an ordinary Roth IRA conversion, minimizing the impact of the law.

The new tax deal (known formally as the American Taxpayer Relief Act) modifies the original 2010 rules by allowing clients to make in-plan conversions even if they are not eligible to take a distribution from the plan. That broadens the impact considerably: Many more clients will now be able to make this type of conversion.

Lawmakers included the in-plan conversion rule changes as a revenue raiser. Many have already questioned its status as a true revenue raiser and believe adding this option will cost the government in the long run.



Just because the new law makes it easier for clients to make in-plan conversions doesn't mean all clients with 401(k)s or similar plans will be able to make them.

Many plans don't even offer a Roth component. And not all plans with Roth options allow in-plan conversions; both the Small Business Jobs Act and the fiscal cliff deal left them at the plan's discretion.

But for those clients who now have the opportunity to make in-plan conversions, you'll need to evaluate two key issues:

* Does a conversion of any type make sense?

* If so, is an in-plan conversion a better option than a Roth IRA conversion?



Any conversion should be considered carefully. The resulting income could impact the client's tax rate, deductions, credits, phaseouts, AMT, exposure to the health care surtaxes and financial aid for which they or their children are eligible.

When determining whether a client should convert, advisors should continue to focus on three big questions.

First, ask clients when they will need the money. Generally, if a client will need the money soon, a Roth conversion does not make sense. (Since these funds are in a plan, this question may be moot; if your clients intend to keep working, they may not have access to the funds for several years.)

The next question to address is where a client would get the money to pay the tax bill on the in-plan conversion. If the client intends on using assets from an existing retirement account to help cover the taxes, the conversion almost never makes sense.

The final and critical question for clients is this: What do you think your future tax rate will be? For clients who believe they will be in a lower tax bracket in the future, a Roth conversion now probably does not make sense. But if the client believes the future tax rate will be higher, it's worth considering a Roth conversion now. Remember, just because the latest tax rates are being called "permanent" does not mean Congress can't pass a new law increasing them down the road.



If a Roth conversion is the right move for your clients, the next step is to determine whether an in-plan conversion is right for your client.

Perhaps the biggest downside to an in-plan conversion is that there is no way to recharacterize, or undo, the conversion. This creates a number of complications and planning concerns.

For starters, the ability to pay the resulting tax bill becomes far more important on an in-plan conversion. If clients have unexpected difficulties paying the tax on a Roth IRA conversion, they have until Oct. 15 of the year following the year of conversion to recharacterize the move, eliminating the tax bill. The decision to make an in-plan conversion, however, is irrevocable - as is the resulting tax bill.

Therefore, be sure you have taken into consideration such possibilities as a client's loss of employment or disability prior to recommending an in-plan conversion. If your clients can't pay the tax bill, they will be in deep trouble.

Even if clients have more than enough money to pay the tax bill, the lack of a recharacterization option creates other issues. What happens, for instance, if a client's account value drops precipitously after converting?

While you would obviously try to avoid this in any account, the consequences would be far worse after an in-plan conversion. At least with a Roth IRA conversion your client could recharacterize to avoid paying tax on lost value; with the in-plan conversion, however, your client will be stuck paying tax on the value initially converted.

In-plan conversions also limit certain planning strategies, such as the cherry-picking of losing accounts. While the tax code does not allow clients to recharacterize specific (poor-performing) investments within a Roth IRA account, investors can choose the Roth IRA accounts they would like to recharacterize.

This subtle difference offers the strategy of converting to multiple accounts so that you can cherry-pick winning accounts and recharacterize other accounts that contain losing investments.



The lack of a recharacterization option is probably the biggest potential drawback of an in-plan conversion, but there are other differences to be aware of.

One reason some clients prefer Roth IRAs over traditional IRAs is that Roth IRAs have no required minimum distributions - but the same cannot be said for Roth 401(k)s and other in-plan Roth accounts. Once clients turn 701/2, they must take these required distributions - unless, in some cases, if they are still working. The distributions can be sidestepped easily, however, by rolling the Roth 401(k) into a Roth IRA one year before they are required.

Other complications to watch for include separate five-year clocks for Roth accounts maintained in different plans, as well as in-plan Roths' complicated pro rata distributions to balance taxable and nontaxable withdrawals - a difference from the ordering rules applicable to Roth IRA distributions.



Despite these potential pitfalls, in-plan Roth conversions will indeed make sense for some clients.

Those likely to benefit most from the new changes are young clients who plan on remaining with their employers for the foreseeable future. Prior to the changes in the fiscal cliff tax deal, these clients likely had little or no opportunity to make in-plan Roth conversions: The ability to take a distribution of plan funds is generally limited for clients who are still working for the plan sponsor and are younger than 591/2. Under the new rules, however, these clients may be able to convert their plan assets immediately.

Other clients who might benefit from in-plan Roth conversions are:

* Clients concerned about creditor protection who live in a state with poor protection for Roth IRAs.

* Clients who wish to use Roth plan funds to purchase life insurance, which is a prohibited investment in Roth IRAs.

* Clients who want to use a loan to access their Roth funds (a prohibited transaction in a Roth IRA).

Other clients who want to mitigate some of the pitfalls of the in-plan Roth conversions may choose to do partial conversions over a number of years, rather than converting an entire employer plan account balance. This would help allay concerns about the lack of a recharacterization option and help reduce the impact of higher income on their tax returns.



Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of several books on IRAs.

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