Until December 31, 2010, taxpayers with an IRA or 401(k) plan have the option to convert to a Roth IRA, report the income tax over 2010 and 2011, and avoid the income taxation upon subsequent withdrawal. (The taxpayer may elect to recognize all of the income in 2010). The recent enactment of The Small Business Jobs and Credit Act of 2010 (the “Act”) will now allow the conversion of Employee Retirement Income Security Act (“ERISA”) qualified 401(k) plans to Roth accounts.
Asset Protection Alert: Often, a client’s CPA, not familiar with the nuances of asset protection laws, will advise their retiring clients to move their qualified plan accounts to an IRA. Similarly, there has been much written about the income tax advantages of converting to a Roth IRA. Nonetheless, in light of this new Act, the decision to convert one’s 401(k) plan to a Roth account must be made carefully considering the tax and non-tax consequences of the conversion. For example, changing a 401(k) to a Roth IRA could result in the individual leaving the cocoon of the ERISA’s asset protection for the limited protections of the IRA. IRA protections vary depending on the taxpayer’s state of residence and whether the taxpayer is in bankruptcy . (The Federal bankruptcy exemption for IRAs is $1,000,000.00. The exemption is unlimited in an ERISA qualified plan.)
Therefore, although there are many reasons why one might consider converting to a Roth IRA (these reasons were covered in an earlier Client Alert and are outside the scope of this article), the decision of whether to transform an ERISA qualified 401(k) to a Roth account must be carefully considered in the context of both income tax benefits and the potential loss of certain asset protection advantages.
If asset protection is not a concern, then a person considering such a conversion may find it more advantageous to convert to a Roth IRA rather than a Roth 401(k). Doing so can provide greater flexibility with investments, beneficiary designations, portability and the ability to qualify for “recharacterization.”
Recharacterization is the process of undoing a conversion to a Roth account if the decision to do so proves unwise. While recharacterization is available for IRAs, the new Act does not provide for recharacterization with respect to 401(k)s. Without the recharacterization provision, there is no “escape” from a Roth conversion gone badly. If tax rates increase substantially, if the securities markets fall or if a client’s income changes dramatically, the Roth 401(k) will not avoid the taxpayer’s payment of a hefty conversion tax.
Skilled financial and investment advisors can plan appropriate investment strategies for a Roth 401(k) conversion where recharacterization is not permitted. Such recharacterization strategies are beyond the scope of this article so check with your financial planner or investment advisor to learn about these investment strategies.
Conclusion: The new Act expands the benefits of the Roth IRA conversion to a broader array of qualified retirement plans. One considering converting to a Roth IRA account must weigh the potential loss of the asset protection “firewall” available with the ERISA qualified 401(k) against the limited credit protections of the Roth IRA. Finally, the lack of the recharacterization option of the Roth 401(k) must be taken into account in considering the choice.
*The author wishes to recognize the contribution of Bob Keebler of Keebler & Associates, LLP for his contribution to the author in preparing this article.
For more information about any of the information discussed in this Client Alert, or any other income or estate tax planning or asset protection planning assistance, please contact Jeffrey M. Verdon Law Group, LLP at jeff@jmvlaw.com or (800) 521-0464.