Most people have heard of Roth IRAs, but many people do not know that a Roth version of the 401(k) plan is available as well. Although this type of account became permanent in 2006 with the Pension Protection Act, not every company that offers a standard 401(k) also offers a Roth version. If your company isn’t offering one yet, you might consider asking whether they will, because this option can benefit a lot of employees.
Tax Implications
When it comes to taxes, a Roth 401(k) works much like a Roth IRA. It’s all about when you pay those taxes. With a Roth 401(k), you contribute to the plan with after-tax dollars, so you don’t owe taxes when you start taking distributions. If there is an employee match, however, those funds are usually contributed pre-tax, as with a standard 401(k). As such, you will have to pay tax on the matching portion at distribution.
The Conversion Question
Under certain circumstances, you can convert a regular IRA to a Roth IRA. Is the same true about 401(k) plans? The answer is yes — sometimes.
First, you have to make sure your company allows conversions. If it does and you go through with it, you’ll owe income tax on the amount you’re converting from a tax-deferred 401(k) to a post-tax investment Roth 401(k). You will need advice to accurately calculate the tax hit you’ll take in the year of the conversion, but you can estimate this on your own. For example, if you’re in the 24% marginal tax bracket, just multiply the amount you’re converting by 24%. And try to pay for the conversion with cash outside your retirement account.
You have until you file your taxes to come up with the cash, but once those taxes are paid, you won’t have to worry about them later. Finally, note that each company that allows a conversion may have its own particular procedures.
Is Conversion Right for You?
Choosing between a traditional or Roth 401(k) hinges on your current and future tax rate. If you expect that your tax rate is going to be higher in retirement, consider the Roth 401(k). If you think that your tax rate will be lower in retirement, consider a traditional pre-tax 401(k). The challenge with this choice is that it’s hard to predict what your future tax rate will be.
You don’t have to make an either/or decision. You may choose to be tax-diversified by funding both types of accounts and you’ll have tax flexibility today and in the future. So, if you decide a Roth 401(k) is a good fit, convert a portion of your regular 401(k) account balance to jump-start your Roth strategy.
A Roth 401(k) conversion can be a good move, but it is not necessarily right for everyone. Careful analysis is necessary.
