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Reasons to Consider a Roth 401k Conversion

You have heard of converting your Traditional IRA to a Roth IRA in order to work toward a tax-free retirement. But did you know you can convert your Traditional 401k to a Roth 401k?

More Employers Offering Roth 401k

To convert to a Roth 401k your employer must first offer this flavor of 401k plan. If your employer only offers a Traditional 401k then there's nothing you can do (other than working to convince your benefits department to offer a Roth option).

But the number of employers offering a Roth 401k is on the rise, so first check with your employer to see if this account is an option for you. If it is, consider converting to a Roth 401k.

Why to Consider a Roth 401k Conversion


Photo by MIKI Yoshihito via Flickr
We showed you how to convert to a Roth 401k, but just because you can convert doesn't necessarily mean you should. Here are five reasons to consider this type of conversion.

Investigating Your Options is Healthy

Just because you consider converting away from a Traditional 401k doesn't mean you have to commit to completing the conversion. Looking at your retirement options in greater detail, whether 401k, IRA, or taxable accounts, is healthy. By digging deeper you are increasing your investing knowledge. When you are looking at your accounts, you may notice your asset allocation is out of whack or that your expense ratios are too high for some of your mutual funds. The greater your understanding of your options, the better off you should be for retirement.

Believing Higher Taxes are Coming

As with IRA conversions, one of the best reasons to convert to a Roth 401k is the belief that higher personal income tax brackets are coming. If you fall into the 25% tax bracket today, but believe that will inevitably be higher in retirement (30%+), then paying the lower tax amount today is a smart move. When you convert to a Roth you pay tax now and never have to pay it again in the future.

Avoiding Required Minimum Distributions

For tax-deductible accounts (Traditional 401k and IRA, 403b, and so on), you are required to begin taking minimum distributions for retirement by age 70 and 1/2. Even if you have no need for the additional income, the law requires you take the distribution so you will start paying income tax on your nest egg.

With accounts that are funded with post-tax earnings like the Roth IRA and 401k, there are no required minimum distributions. You can keep your nest egg intact as long as you like and even it will it to your heirs.

Not Committing to Only One Option

By looking or completing a conversion of your 401k, you are not required to stick just with that new plan. By converting your Traditional 401k today, you could decide to start contributing funds to it again in the future. Your future contribution path is not determined by your past conversion decisions.

Paying Less Tax Due to Market Conditions

If your investment portfolio has taken a recent dip due to market conditions, converting is a great way to save on the taxes owed. The amount of tax owed is calculated by the amount of funds converted. If your 401k sits at $20,000, you fall in the 25% tax bracket, and you convert to a Roth 401k you will owe $5,000 in taxes. You would hopefully pay those taxes out of pocket rather than out of your portfolio, but even if your portfolio took the hit you would end up with $15,000 in your Roth account.

But if your 401k had fallen to $14,000 due to a massive market drop off, you would only pay $3,500 in taxes. By investing for the long term and making the change at the lower portfolio amount, you've essentially saved on the total tax you will pay for retirement.

This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.

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Important Roth Information

Each year, the IRS updates the rules for Roth IRA. Here are all the details for 2013 & 2014: