Roth, 401(k), annuity changes included in small business law

DES MOINES, Iowa — Anyone saving for retirement should be paying attention to the small business bill president Obama signed last month.

That’s because in addition to tax changes and other incentives for business owners, it also extends three benefits to workers saving for retirement.

Two of the new rules allow participants in workplace retirement plans to transfer money into a Roth account without paying a penalty. The third allows savers to more easily convert some of their money into an annuity.

The focus on Roth accounts is important for tax planning. That’s because workers with 401(k) accounts put aside a portion of their pre-tax income from each paycheck. Then in retirement, the accountholder pays taxes when the money is withdrawn. This differs from a Roth account, where money is put in the account after taxes have been paid, but withdrawn in retirement tax-free.

The ability to draw money from both taxable and nontaxable accounts allows a retiree to better control tax liability. With the possibility of some of the Bush-era tax cuts expiring soon, consideration of future tax liability may be increasingly important.

ROTH ROLLOVER

A rule in the small business act allows workers to roll over some of their 401(k) account into a Roth within their retirement plan. The worker must pay the taxes due but they won’t face an additional penalty. Typically, rolling over a 401(k) into a Roth IRA before age 59 1/2 resulted in taxation of the funds plus a 10 percent penalty.

The IRS also is allowing the individuals to pay the taxes due from a Roth conversion, if done in 2010, to be spread out. Some can be paid in 2011 and the remainder in 2012.

Although it may seem like a timely benefit for the government to offer, there is an ulterior motive. One estimate says that over 10 years, Roth conversions will generate an additional $5.1 billion in tax income.

Another provision adds the Roth option to government 457 retirement plans in 2011. Current law allows Roth accounts in 401(k) plans and their nonprofit equivalent, the 403(b), but not the retirement plan for government workers.

Tax revenue estimates from allowing these conversions have been estimated at $506 million over 10 years.

The third retirement-oriented change tucked into the small business bill involves allowing annuity owners to take out part of the money and convert it to a new annuity.

An annuity is an insurance company product in which a person turns over a sum of money, in turn the insurance company invests it and guarantees the customer a set payment every month.

The annuity industry has been pushing for the change for at least five years because it offers a little more flexibility in the way the investment may be used, said Drew Denning, vice president of retirement services for Principal Financial Group Inc., a Des Moines, Iowa-based financial services company.

Many retirees who may consider an annuity are reluctant to commit their entire life savings to an annuity contract out of fear that they may need money for unforeseen medical expenses or other surprises.

“A more gradual conversion or partial purchase is more appropriate for most individuals,” Denning said.

Many advisers recommend retirees annuitize at least enough of their savings to pay for the basic necessities such as housing, food, and transportation. This gives them flexibility to spend the remainder of their retirement funds as needed, while ensuring that the basics are covered by the annuity payment.

The new law will help someone who has purchased a fixed deferred annuity, a product in which the account grows tax deferred for a definite period — perhaps five or 10 years — before the owner begins taking money out. But, the owner may decide to begin collecting on at least some of the funds now by converting a portion of that account into an income stream while leaving the balance in the account earning income on a tax-deferred basis, explains Walter Welsh, executive vice president for taxes and retirement security at the American Council of Life Insurers.

This provision is expected to raise $965 million over 10 years for the federal government.