The American Taxpayer Relief Act of 2012 (the Act) resolves income, estate and gift tax uncertainty with “permanent” changes effective starting in 2013. Although the Act preserves the Bush era tax rates for most taxpayers, it does not extend the two percent cut in the employee portion of Social Security payroll tax that was in effect during 2011 and 2012. As a result, Social Security payroll tax will go up from 4.2 percent to 6.2 percent for all employees and from 10.4 percent to 12.4 percent for the self-employed. Higher income taxpayers will also be subject to increased income tax rates as well as an additional Medicare surtax on most categories of investment income.
The Act also creates an opportunity for taxpayers of all income levels who participate in a 401(k) plan that includes a Roth contribution account. Under prior law, participants could not transfer amounts from traditional 401(k) accounts to Roth accounts in the same plan until they attained age 59 1/2 or left their employer. The Act repeals this requirement and allows participants to make the transfer from a traditional 401(k) account to a Roth retirement plan account at any time. This transfer is a taxable event but participants who are currently in lower tax brackets and higher bracket taxpayers who anticipate significant growth in their 401(k) accounts may want to pay the tax now so they can take tax-free distributions later on.
Recommendations: Not every 401(k) plan currently offers participants Roth contribution accounts (see here for background details on Roth 401(k) accounts). In order to allow participants to make the transfer now permitted by the Act, the plan document would have to provide Roth contribution accounts and add the new option for participants to transfer funds to the Roth account from their conventional 401(k) accounts. This makes Roth accounts more attractive to a larger number of participants and plan sponsors may want to add this feature to their 401(k) plans as early in 2013 as possible. Volume submitter and prototype documents with appropriate provisions may not be available for a few months, so plan sponsors should consider a custom amendment to their 401(k) plans so that participants can transfer funds earlier in the year when their account balances (and the corresponding tax bite) are likely to be smaller.