Should You Convert a Traditional 401(k) into a Roth 401(k)?

If your company offers a Roth 401(k), you can convert your traditional 401(k) to pay lower taxes in retirement.

BY TOM TAULLI PUBLISHED 11 JUNE 2024

You may be able to convert your traditional 401(k) into a Roth 401(k) if your employer offers both types of plans. It boils down to when you want to pay taxes on your retirement savings: while you are working or when you are retired.

Last year, the number of 401(k) millionaires grew by 20% to 422,000, according to research from Fidelity. The average balance was over $1.5 million.

However, when 401(k) holders start to withdraw their money, they could face significant tax liabilities. Then what to do? One option is to convert a 401(k) into a Roth IRA.

Yet the ability to make this move depends on several factors, such as your age, cash available to pay current taxes, and expectations of future tax rates. Given that a conversion is a major financial decision, you should seek the assistance of a qualified financial planner or tax advisor.

Why convert a traditional 401(k) into a Roth 401(k)?

Tax savings. The biggest advantage of a conversion is the potential tax savings. Let’s take an example. Suppose you are 60 years old and have $100,000 in your 401(k). You are in the 24% federal tax bracket.

You plan to retire when you reach 70 and expect to be in a higher tax bracket. The reason is that you anticipate having higher income from investments and part-time consulting work.

If you convert your 401(k), $100,000 will be transferred to the Roth 401(k). You will then pay $24,000 in taxes; this example assumes you are not paying taxes from your Roth account but are leaving all $100,000 invested.

Assuming a 7% average annual return, the account will grow to $196,715 in ten years. If you did not do the conversion and wind up in the 28% tax bracket, your total tax owed on a distribution would be $55,080.

With your Roth IRA, you can make distributions tax-free whenever you want. Based on this scenario, you would owe $31,080 less in taxes.

Granted, this is a simple example. But this gives a general idea of the tax advantages.

Flexible distribution schedule. You are not subject to required minimum distributions (RMDs). This is when you need to withdraw a minimum amount each year from a retirement account. The rule kicks in when you reach age 73 (or when you reach age 75 after 2033). If you do not make the required distributions, you must pay taxes on the withdrawals and a 25% penalty.

Not having to pay RMDs provides more flexibility in retirement. By leaving your money in the Roth IRA, you will have more opportunities to grow your account.

Benefit to your heirs. You can also potentially leave more money to your heirs, and no taxes may be owed. There are some limitations, however. For a tax-free transfer to your heirs after your death, you must have had the Roth IRA open for at least five years and be at least 59 1/2. The distribution will be subject to taxes and a 10% penalty if not.

How to convert to a Roth 401(k)

The conversion process is straightforward. First, you will need to set up a Roth IRA account. Then, you will notify the plan administrator for the 401(k) to get the necessary forms.

“It’s a matter of reaching out to the 401(k) administrator and letting them know where the balance should be deposited,” said Liting Chuang, who is the Director of Tax Planning and Associate Wealth Advisor for Bordeaux Wealth Advisors. “We always recommend clients do a trustee-trustee rollover to avoid any issues down the road.”

Sometimes, a conversion may not be an option with the plan administrator. In this case, you can roll over the 401(k) into a traditional IRA (Individual Retirement account) and then make a conversion to a Roth IRA.

The Downside

A big tax bill: For a conversion, you may have to pay a substantial amount in taxes. Even if you have enough liquid assets for this, you could have challenges dealing with future emergency expenses. 

Complexity: The evaluation of a conversion can be extremely complex as well. “The unknown for what the future holds would be the biggest downside,” said John Foard, a CFP® and the co-founder of Crown Advisors, LLC. “The reality is no one can predict the future and you will never truly know if doing a Roth conversion worked out until you complete it and get to retirement.

Only then, knowing what tax rates are and how your portfolio has grown over time, will you truly know if this was a good idea.” But you do not have to have a full conversion of your 401(k). You can use a smaller amount or make conversions over time.

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