Tax Bill Will Reduce 401(k) Taxes, Ease Fund Transfers

More employees will be able to reduce the taxes they pay on 401(k) plan distributions under tax legislation given final congressional approval Jan. 1.

A provision tucked into the American Taxpayer Relief Act 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) plan 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 a traditional 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.