A recently enacted law opened the door for more workers to convert their pre-tax 401(k) accounts to Roth 401(k) accounts. Should you do it?
GOOD NEWS for participants in 401(k), 403(b), or 457(b) retirement plans: These plans may now allow all participants to convert amounts in their pre-tax accounts to Roth accounts within the plan. Prior to 2013, only those participants who were eligible for a distribution were allowed to do a Roth conversion. This usually meant that you either had to be at least age 59½ or had to have left the company. The American Taxpayer Relief Act of 2012 lifted that restriction. So if your retirement plan offers a Roth account option and allows in-plan conversions, you have a new choice regarding your pre-tax savings… to Roth or not to Roth.
Before you make a move, though, it is important to understand the differences between traditional and Roth accounts. Here’s the deal. Income you contribute to a traditional account is pre-tax, meaning that you have not paid income tax on it yet. Tax is deferred until you withdraw money from the account, at which time your withdrawal will be subject to income tax.
Contributions to a Roth account are aftertax. So if you convert the pre-tax savings in your traditional account to a Roth account, the pre-tax amount you convert will be subject to income tax this year. After that, however, your Roth investment earnings and withdrawals will be tax-free, as long as you follow the rules for withdrawals.
The question is: Are you better off paying tax on your savings now or waiting until later when you withdraw money from your account? Your answer will depend in part on whether you think your marginal income tax rate will be higher or lower in retirement than it is now. Of course, no one can predict for certain what tax rates will be in the future, but you may be able to make some assumptions based on your situation. For example, if you are in the early years of your career and expect your salary and your marginal income tax rate to increase over the years, you may pay less tax if you convert and take the tax hit now while your tax rate is relatively low. On the other hand, if you are in your peak earning years and expect that your marginal income tax rate may decrease in retirement, this may not be the best time to convert to a Roth account.
Another factor to consider is whether you can afford to pay the taxes at this point. If you convert to a Roth account, you will have to add the pre-tax amount of the conversion to your gross income for the year, which will typically drive up your taxes for the year of the conversion. Your tax advisor can help you estimate the tax impact.
All in all, converting to a Roth account is a big decision. Your tax and financial advisors can help you decide if it is the right choice for you.
TRADITIONAL 401(K) ACCOUNT
- Your contributions are made from pre-tax income, which helps lower your current income taxes.
- Earnings grow tax-deferred.
- Withdrawals are subject to income tax.
ROTH 401(k) ACCOUNT
- Your contributions are made from after-tax income, meaning that your contributions are subject to income tax in the year you make them.
- Earnings grow tax-free.
- Withdrawals are tax-free, provided you follow the rules.
- Early distributions from both types of accounts are generally subject to a 10% tax penalty.