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The Impact of the American Taxpayer Relief Act On Your Retirement Savings

The fiscal crisis of 08’ brought a number of changes in our personal finance. Most importantly, retirement savings became a focal point of discussion.

The most important regulation enacted by Congress since the fiscal cliff was the American Taxpayer Relief Act of 2012 which was signed into law on January 2, 2013. The Act gives permanence to the lower rate of much of the Bush tax cuts, while retaining the higher tax rate at upper income levels that became effective on January 1 as a result of the expiration of the Bush tax cuts.

It had a positive impact, with the addition of  Roth contributions have consequently become significant on a comparative scale.

Roth Contribution Provision

ID-10097428The Taxpayer Relief Act created a bit more flexibility in using a Roth IRA option to your retirement plan. The Act allows individuals to convert their existing 401(k) plan to a Roth 401(k) plan — if your plan offers designated Roth accounts. This provision allows such intra-plan Roth conversions for 401(k) plans much in the same manner the tax code permits conversions from traditional IRAs to Roth IRAs, which requires the individuals to pay tax on the value of the conversion.

Before the Taxpayer Relief Act was enacted, participants in accounts such as 401 (k), 403 (b) or 457 could convert to a Roth account. But only at the time of a ‘qualifying event’ (separation from service or retirement). So you only had one opportunity to do the conversion. The American Taxpayer Relief Act 2012 has amended the tax code so that there is no longer a need for a qualifying event to convert to a Roth account.

The Benefit of Roth

In the case of a traditional tax deferred retirement option, contributions are made pre-tax and the savings grow tax deferred. But the money is then taxed as you withdraw it during retirement. So you save some taxes up front because your IRA contribution is not taxed.

But, in a Roth IRA, contributions are made on an after-tax basis. So you pay taxes up front but the savings are allowed to grow without being taxed and most importantly,  withdrawals aren’t subject to federal taxes either. So if you invest $4000 and 20 years later it grows to $40,000 with a traditional IRA you save the taxes on $4,000 but with a Roth you save taxes on $40,000.

A study published in the Wall Street journal last year indicates that a number of prominent sponsors have added the Roth option. Not only that, there is an increase in the shift as well.

In the case of Vanguard, the Roth option for 401 (k) has increased by 12%. Fidelity, another sponsor, indicated a 32% increase. The highest shift was noted from Schwab IRA, which showed an increase of a mammoth 66% for Roth conversions.

The Benefit of  a Roth Conversion

Let’s look at a traditional retirement plan, a Roth retirement plan and a Roth IRA to understand their impact and benefits.

Tax Implications

In the case of a traditional pre-tax retirement plan account, the employee contributions are made before taxes. In the other two cases, the contributions are made after tax. The savings grow tax deferred (allowing them to grow faster) for traditional retirement plans while they are tax free for both Roth types.

Contribution Limit

For the traditional pre-tax and Roth retirement plan account, the IRS maximum is the same. It is $17,500 (for 2013) with a $5,500 catch-up contribution for age 50 and above. However, in the case of Roth IRA, it is $5,500 (for 2013) with a $6,500 catch-up contribution for age 50 and above. So you can contribute significantly more to a retirement plan than to an IRA.

Income Limits

Income limits are only applicable in the case of Roth IRA.

Required Minimum Distributions

The Roth IRA does have an advantage in that that there are no minimum distributions.

The IRS puts it this way: You are not required to take distributions from your Roth IRA at any age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs as explained later under Distributions After Owner’s Death.”

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Image courtesy of Stuart Miles / FreeDigitalPhotos.net.