'Fiscal cliff' bill offers new options on Roth 401(k)s

The "fiscal cliff" bill will give more workers a chance to convert some or all of their 401(k) account balances into a Roth 401(k), but only if their employer offers a Roth option and allows the conversion.

This is one of the few revenue-raisers in the American Taxpayer Relief Act of 2012. It is expected to generate $12.1 billion in taxes over the next 10 years, enough to pay about half the cost of delaying federal spending cuts for two months, until March 1.

But long-term, outside the 10-year budget forecasting window, the Roth provision will cost the Treasury money.

"I get a kick out of the fact they keep it as a revenue-raiser. Long-term, they are giving the store away," says Jeffrey Levine, a certified public accountant with Ed Slott and Co.

Here's why: With a traditional 401(k), you pay no income tax on money you put into the account and it grows tax-free. But every dollar you take out is taxed as ordinary income.

With a Roth 401(k), you pay tax on money that goes into the account, but it grows tax-free and remains tax-free when you take it out, as long as you had the account for more than five years and you are at least 59-1/2, dead or disabled.

When you convert money from a traditional 401(k) into a Roth 401(k), you owe income tax on that amount in the year of the conversion, but from then on it enjoys the tax-free future of a Roth account.

It's not clear how popular the new conversion option will be.

Congress allowed employers to offer a Roth option in their 401(k) and similar workplace retirement plans starting in 2006. Today, about 40 percent of larger employers offer a Roth option. But only 8 percent of the employees offered the Roth option use it, according to a 2011 survey by Aon Hewitt. Originally, workers could only contribute new money into the Roth option -- they could not convert existing 401(k) balances into a Roth as long as they stayed with that employer.

When they leave a job, workers can convert their traditional 401(k) into a Roth individual retirement account, which has similar rules as a Roth 401(k).

In 2010, Congress gave employers the option of letting employees convert from a regular 401(k) into a Roth 401(k) while they were still employed -- called an in-plan conversion -- under very limited circumstances.

The new legislation removes the restrictions on in-plan conversions so employers can offer them to all employees. The new rules "may encourage plan sponsors who have not done so to implement a Roth feature in their plan," says Mike Shamrell, a spokesman for Fidelity Investments.

For workers, the Roth conversion only makes sense if you think your tax rate is lower now than it will be when you retire and begin withdrawing money from the account, says Michael Kitces, research director with Pinnacle Advisory Group.

Most people with large 401(k) balances are probably in their peak earning years and assume their tax rates will drop in retirement. That could change if Congress musters the courage to really attack the deficit.

Converting makes more sense for "for younger workers whose income hasn't ramped up yet," Kitces says. Anyone who makes the conversion must have enough cash outside their 401(k) account to pay the tax that will come due. That could be a problem, especially for younger workers.

Levine says some people may be caught off guard when they find out they can't undo a Roth 401(k) conversion, like you can -- within a certain time period -- if you convert a traditional IRA into a Roth IRA.

Even so, there is an advantage to having some money in traditional and some in Roth accounts. "It gives the participant the opportunity to manage their own taxes in retirement," says Craig Rosenthal, a partner with consulting firm Mercer.

"They can withdraw from one sub-account or the other with different tax implications. They can balance their withdrawals potentially to keep them in a lower tax situation."