Commentary: The bad equity markets have one silver lining for those executives in your organization that might have large 401(k) account balances: In-plan conversions to Roth 401(k) accounts.
Most of us have experienced significant declines in the value of our 401(k) account balances as a result of weak equity markets. For executives, these losses may have been even greater if they had a well diversified 401(k) account with a heavy allocation to equities and exposure to commodities. These executives may have unrealized losses in their accounts of as much as 20% or 30%.
Converting pre-tax 401(k) balances into after-tax Roth 401(k) balances results in taxation of the previously tax-free amounts. Converting when the account value is lower may result in a substantial tax savings. Following is an example.
In-plan Roth 401(k) conversion example
Let's assume one of your executives has a $1,000,000 account balance and is interested in converting 20% of it into a Roth 401(k) account. Prior to the recent decline in market value, assume that the existing $200,000 slice of this executive's account was worth $300,000. In other words, assume the executive has experienced a 33% decline in the value of his/her account.
Taxes are due on any amounts converted into Roth 401(k) accounts. So the executive would owe state and federal income taxes on the $200,000 of his/her account balance that was converted. However, the executive would save paying taxes on the difference between the previous value of $300,000 and the current value of $200,000. In this example, an executive subject to a combined 30% state and federal tax rate would save $30,000 in taxes, and possibly much more.
Additional benefits of Roth 401(k) accounts
Roth 401(k) account balances residing in the accounts for five or more years and withdrawn for permissible reasons are not subject to any state or federal taxes when distributed. We know the markets will bounce back and assuming that this executive experiences a reasonable rate of return for the next 10 years, his/her tax savings on the $200,000 that is converted and withdrawn completely tax free sometime in the future could be enormous.
What you should do
Roth 401(k) in-plan conversions can benefit almost any plan participant. In order for your 401(k) plan to permit such exchanges, it needs to allow for Roth 401(k) accounts and in-plan conversions. If your plan currently isn't structured this way, don't worry, all you need to do is amend it.
There aren't many benefits your executives can enjoy these days. Consider sharing this opportunity with them.
Robert C. Lawton, AIF, CRPS is President of Lawton Retirement Plan Consultants, LLC, a RIA firm helping retirement plan sponsors with their investment, fiduciary, employee education and compliance responsibilities. He may be contacted at firstname.lastname@example.org or 414.828.4015.
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