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News & Announcements

Tax act expands Roth conversion opportunity

February 26, 2013

On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act (ATRA), the result of an agreement between Congress and the Administration to help prevent the federal government from “going over the fiscal cliff.”

ATRA, which is expected to raise more than $600 billion in new revenue over 10 years, permanently extends the Bush-era tax cuts and creates a new, higher tax rate for high-income individuals and families. (See more ATRA highlights.)

The Roth IRA opportunity

ATRA also makes it easier for retirement plan participants to convert pretax retirement plan balances to in-plan Roth (after-tax) accounts, a change that could raise more than $12 billion over 10 years.

The following Q&As provide more insight into the Roth IRA rule change:

Q: To which retirement plans does this rule change apply?

A: The new rule applies to all 401(k), 403(b) and governmental 457(b) defined contribution retirement plans that permit participants to make elective deferrals to a Roth account.

Q: How does ATRA change the previous rule?

A: ATRA permits conversion of otherwise nondistributable amounts, such as pretax employee contributions (elective deferrals), making the option available to any participant, not just those who qualify to take a distribution.

Q: Is this a permanent or temporary rule change?

A: It is a permanent rule change.

Q: What are the tax implications of a conversion?

A: Conversion amounts are subject to ordinary income tax in the year of conversion. Subsequent distributions from the Roth account could be made tax-free if certain conditions are met.

Q: Are plan sponsors required to add the new rules to their current in-plan Roth conversion rules?

A: ATRA neither requires sponsors to adopt the new rules nor indicates how much flexibility a plan sponsor will have in setting limits on amounts eligible for conversion. The industry anticipates guidance from the IRS.

Q: Do plan sponsors have to handle tax withholding from the conversion amount?

A: Under prior law, IRS guidance permitted, but did not require, plan sponsors to withhold from conversion amounts for income taxes. Pending IRS guidance to the contrary, nothing in the new law changes this rule.

Q: What does an employer without a Roth account option need to do to add an in-plan Roth conversion opportunity?

A: Plan sponsors must first amend the plan to accept Roth contributions before adopting an in-plan Roth conversion provision. ATRA did not change this requirement.

Q: If a plan already offers a Roth account option, does the sponsor have to do anything?

A: It’s too soon to tell. Some speculate that the IRS may require separate accounting of converted nondistributable amounts. Also, open questions remain for issues such as dealing with partially vested or unvested amounts, timing for amendments, and applicable restrictions of certain money types. We expect additional guidance from the IRS in the near future.

Q: What are the benefits of an in-plan Roth conversion, as expanded by ATRA?

A: An in-plan provision, as expanded by ATRA, empowers the individual to determine when to pay taxes on the retirement plan assets.

For more information about how your plans can benefit from the new rule, either by adding a Roth account to a plan or by amending the plan document to permit the expanded conversion rights, call American Funds at 800/421-9900.

 

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from your plan’s financial professional and should be read carefully before investing. This information may vary regarding group annuity investments and, if applicable, can be obtained from a financial professional.