Why Switch to a Roth 401(k)?
Beginning in 2013, you could roll over all your standard 401(k) funds to a Roth account in the same retirement plan. But such a move may not be good for you. While the upside of a Roth is tax-free money in the future, converting creates an extra tax burden today.
The Roth 401(k) in-plan conversion allows participants in 401(k), 403(b) and 457 deferred compensation retirement plans to convert funds from the traditional account into the designated Roth account that is part of the plan. Previously, an employee could only convert funds from the 401(k) plan to a Roth-like account when he or she leaves the job with the sponsoring employer.
It’s not a requirement for employers to provide this new in-plan conversion feature, but if your employer amends the plan documents to allow for it, you may convert any or all vested funds from the traditional 401(k) plan into your Roth 401(k) plan. “Vested” means the amount of company contributions into your plan that is yours to do with as you want. Not all the money in your account is always vested. Typically, you need to stay on the job for several years before that money is 100% vested. If you leave before that, the employer gets to pull some or all of it back.
But the Roth in-plan conversion is not a very attractive option. The Internal Revenue Service treats the conversion as a withdrawal from the 401(k) plan, so ordinary income tax applies. The amount you convert shows up on your tax forms as taxable income for the year, along with your wages and other income. This could push you into a higher tax bracket since the federal ordinary income tax rates are progressive – the more you earn, the higher your rate.
For example, if you are single and your regular taxable income is $75,000, your marginal tax rate, meaning the rate at which your last dollar of income is taxed at, is 25%. Your average tax rate on this $75,000 of income is 19.47%. If you enact an in-plan conversion of $25,000 from your 401(k) to your Roth 401(k), your taxable income is now $100,000. The marginal tax rate on this level of income is 28%, and the average tax rate is 21.18%. You pay $6,569.50 more in tax, so the real tax cost on that $25,000 conversion is 26.28%.
You generally do not have access to plan funds to pay this tax, so you must pay up from elsewhere. Keep in mind as well that Roth 401(k) funds are subject to required minimum distributions. You have to start taking out funds when you reach 70½, just like traditional 401(k) funds. You can side-step this by rolling over the funds from your Roth 401(k) account to a Roth individual retirement account after you leave the employer, because Roth IRAs do not have this requirement.
When does a Roth in-plan conversion make sense?
Low income. If you have a relatively low income, or if you have variable income (such as farm income or sales) and you expect this year’s taxable income to be lower than other years, converting some or all of your vested 401(k) plan balance to a Roth is a smart move. Again, you must have non-401(k) account money to pay the additional tax.
Estate Planning. If you don’t expect to use the 401(k) funds for your own purposes in retirement, and you’d like to pass along the money to your spouse or kids, conversion to a Roth eliminates the tax burden for them.
Higher tax rate expected. If you read the tea leaves and believe that your future tax rate is higher, converting funds to a Roth can be a way to reduce your overall tax cost.
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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.
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