Fiscal cliff bill would reduce 401(k) taxes, ease fund transfers

401k stone

More employees will be able to reduce the taxes they pay on 401(k) plan distributions under tax legislation intended to resolve the fiscal cliff.

A provision tucked into the American Taxpayer Relief Act, which President Barack Obama signed Wednesday, will expand the opportunities for employees to transfer funds from traditional 401(k) plans to Roth 401(k)s. Employees who are in lower tax brackets now compared with when they retire will reap big tax savings from such transfers.

Under current law, employees can transfer account balances from traditional 401(k) plans to Roth 401(k) plans if certain conditions are met. The appeal of such transfers is potential tax savings. When the funds are transferred to the Roth 401(k), employees are taxed on the amount of the distribution. After that, the funds earn tax-free income. By contrast, in a traditional 401(k) plan, employees make pretax contributions and investment income on the contributions are not taxed while the money remains in the plan. However, the money is taxed when distributed, such as when the employee retires.

Through an approach of transferring funds from a 401(k) plan to a Roth 401(k) plan, employees could cut taxes they would pay on plan distributions. Take the case of employees in a low tax bracket. By transferring the funds from a traditional 401(k) plan to a Roth 401(k) plan, the taxes owed on the transferred amount could be a lot less than if the money stayed in the traditional 401(k) plan until retirement when the individuals' income could be more and the employees would be in a higher tax bracket.

But under current law, a big chunk of 401(k) plan money, such as' pretax contributions made by employees until they are age 59, are not eligible for transfer to Roth 401(k) plans.

Under the American Taxpayer Relief Act, though, virtually all traditional 401(k) plan account balances would be eligible to be transferred to Roth 401(k) plans.

“This is very big news. It is a tremendous opportunity,” said Alison Borland, vice president of retirement solutions with Aon Hewitt in Lincolnshire, Ill.

“This will appeal to employees who think their tax rates will go up” in the future, said Robyn Credico, defined contribution practice leader with Towers Watson & Co. in Arlington, Va.

More than 40% of employers offer a Roth 401(k) plan feature, according to surveys. But that percentage could increase as more employees ask their employers to add such a feature due to the expanded ability the tax legislation would offer for them to cut taxes they would have to pay on distributions.

Jerry Geisel is editor-at-large at Business Insurance, a sister publication of Pensions & Investments.