A Complete Guide to Roth 401k Conversions

Now anybody can convert an existing 401k into a Roth 401k, so long as your employer offers the Roth alternative.

Roth 401k

Roth IRAs have been a popular form of retirement savings for some time. And while there are income limitations that prevent higher income workers from opening a Roth IRA, since 2010 these limitations have been removed for those converting a 401(k) or traditional IRA into a Roth. Now, thanks to the fiscal cliff deal, you can convert a traditional 401(k) into a Roth 401(k).

Before the deal, conversions to a Roth 401(k) were limited to funds that were “distributable.” As a practical matter, this limited Roth 401(k) conversions to those workers 59 1/2 years of age or older. Now, anybody can take advantage of the conversion. And the conversion can apply to all of the retirement savings in your 401(k), not just the amounts contributed after Congress changed the rules.

As a result, a Roth 401(k) adds yet another option to retirement savings. I have such an account from my last employer. And while the amount is small, it’s nice to know I have some retirement savings that will grow tax-free, not just tax-deferred. And given the recent changes in the law concerning conversions, it’s a perfect time to cover this important retirement account.

Must employers offer a Roth 401k option?

It’s important to understand that not all employers offer a Roth 401k. And they aren’t required to. With the new rules that allow for conversions to a Roth, many experts expect that more and more employers will offer this option. According to a WSJ article, about 50% of employers with 401k plans offer a Roth alternative. The good news is that this number is on the rise.

If your employer doesn’t have this alternative, talk to your HR department about adding it. Perhaps if they hear from enough employees that want a Roth, they’ll add it to their benefit options.

Should I convert to a Roth?

First, understand that if you do convert from a traditional 401(k), the amount you convert into a Roth 401(k) will be taxable income in the year of conversion. You’ll need to plan ahead to make sure you have the funds available to the pay the taxes.

Second, it’s important to consider the advantages and disadvantages of a Roth 401(k). The big disadvantage to any Roth type of retirement account is that you don’t get a deduction for your contributions (in addition to paying taxes on the conversion). But if you think your tax rates will be higher in retirement, paying lower taxes today to avoid higher taxes tomorrow may prove to be a shrewd move.

While there are no hard and fast rules as to when you should convert, the following situations warrant a serious look at converting to a Roth 401(k):

  • You think your taxes are headed up: This is a tough call to make, particularly if you are still relatively young. The question to answer is whether your tax rates are higher today than they will be when you retire. Rates can go up either because the federal tax brackets increase or because you earn more money, which places you in a higher tax bracket. If you think there is a good chance that you’ll pay more in retirement, converting to a Roth 401(k) is a viable option.
  • You’re moving to a state with higher taxes: If you live in a state with no income taxes but are moving to California or another state with high tax rates, converting before you move may pay off in the long run.
  • You want to leave the money to your heirs: With Roth retirement accounts, you don’t have to start taking money out by age 70 1/2. Remember that there are no taxes to pay when you do make a distribution, so the government has no vested interest in when you start using the money. So if you want to leave the money to your children or grandchildren, a Roth 401(k) is ideal. It also doesn’t count toward the value of your estate for tax purposes.

Note that if your tax rate when you make the contributions turns out to be the same as when you take distributions, the amount you’ll end up with will be the same regardless of which option you choose.

Traditional vs Roth 401k

(Source: WSJ)

How does a Roth 401(k) conversion work?

A Roth 401(k) works much like a Roth IRA does. You contribute after-tax money, meaning that you don’t get a tax deduction for your contributions. Buy your investment grows tax-free and you pay no taxes when you take distributions from the account, so long as you have held the account for at least five years and you are at least 59 1/2 years old. And unlike a Roth IRA, there are no income limitations for opening a Roth 401(k), provided that your employer offers this option (more about that in a minute).

Converting an existing 401(k) account into a Roth is simply a matter of filling out the right paperwork. Contact either your HR department or your 401(k) administrator to initiate the conversion. Note that it will likely take a few months for the rules and regulations to be finalized, so you may have to wait until later in the year to make the conversion.

What about an employer match?

This is where things get interesting. If your employer matches some or all of your contribution, the match goes into a traditional 401k even if your contribution goes into a Roth 401k. The result is two separate 401k accounts, one tax-deferred and one tax-free. It may sound more complicated than it really is. You’ll see these two accounts itemized on your statement.

Topics: Retirement Planning

2 Responses to “A Complete Guide to Roth 401k Conversions”

  1. If you’re thinking about leaving the money to heirs then I would think you’d also want to consider the tax rates your heirs pay versus your own. If you’re pretty well off and pay a high tax rate but your heirs are in a lower bracket then I think it may be a net loss to pay the tax today rather than let your heirs pay it. Regardless of the income tax reates, converting to a ROth may be a good way to avoid estate taxes if you’re a multi-millionaire.

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