Should You Convert 401k Saving to a Roth?
Kelli Send, CFP, M.Ed., Senior Vice President -- Client Services at Francis Investment Counsel, explains the Roth in-plan conversion provision and includes a guide to help employees decide if it's right for them.
When Roth 401k deferrals became available in early 2006, we understood the powerful tax diversification benefits it offered employees. We worked aggressively with employers to implement this provision, knowing that with proper education Roth 401k accounts would be embraced by employee populations. After seven years of availability, 93% of Francis advised retirement plans allow Roth deferrals, whereas nationally, only half of the nation's employers permit their employees to save with Roth tax treatment.
Recent legislative changes now allow retirement plans to offer in-plan Roth conversions where participants can convert any existing vested, pre-tax savings into a Roth account. After conversion, all balances, including any subsequent gains, can be withdrawn income tax-free at retirement. Following is a guide to help employees understand in-plan Roth conversions and who is most likely to benefit from them.
How Roth In-plan Conversions Work
First, check to make sure your employer has added this feature. Even though recent legislative changes permit conversions, your specific plan must be enhanced to allow them.
Then, decide how much you want to convert each year. Your deadline is December 31 of each year and the conversion amount will be considered taxable income that year. After your savings are converted to Roth and taxes are paid, all future gains will be income tax-free. (Quick review: with pre-tax savings you get a tax break up front but your savings are taxed as income when you take a withdrawal. With Roth savings, it's the other way around. The amount you save is taxed as income but all withdrawals, including earnings, are income tax free after age 59 ½.)
More Reasons to Like Roth
Did you know that your social security benefits become taxable income as your other income rises? Since Roth distributions are tax-free they do not count as taxable income for taxation of social security benefits. Further, once you reach 70 ½ you generally have to begin taking required minimum distributions (RMDs) from your pre-tax account. Not so with the Roth, provided your account is rolled into a Roth IRA at retirement. Finally, Roth's pass income tax-free to your heirs, so they can be a great estate planning tool.
Understand How Taxes Are Paid
You should have sufficient assets outside your plan to pay the taxes you'll owe as voluntary tax withholding is not allowed on your conversion unless you are eligible for an in-service distribution. Be sure to consider the impact of the conversion on your tax situation as some tax deductions and credits can only be claimed if your taxable income is below certain levels.
Who Should Consider a Roth Conversion
You might want to consider converting some of your pre-tax 401k savings if:
Convert to Fill up Your Tax Bracket
You could consider a partial Roth conversion to "fill up" your tax bracket each year. With this strategy you convert just enough to reach but not exceed the next bracket. For example, if your income places you in the 15% federal tax bracket this year and the 25% tax bracket would apply if you had an additional $5,000 in income, you could convert just under $5,000 that year to "fill up" the bracket without going over.
Convert to Use up Your Tax Refund
If you consistently receive a healthy tax refund consider using some of these refund dollars on a Roth conversion. First, determine the amount of your refund you'd like to absorb then divide that by your tax bracket. What results is your approximate conversion amount to use up that refund. For example, if you are in the 15% tax bracket and want to use $600 of your tax refund for this purpose, you can convert $4,000 ($600 refund/15% tax bracket).
The ability to have both a taxable and tax free source of income in retirement is desirable to just about everyone. If you haven't yet started saving in a Roth account or if you think an in-plan Roth conversion might be right for you, talk to your employer.
Francis Investment Counsel is a fee-only Registered Investment Advisor dedicated to providing independent investment consulting and employee education services to the qualified plan marketplace. The company delivers conflict-free investment advisory services to plan sponsors and also offers extensive education and individualized advice services to plan participants.
The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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