An employer-sponsored 401(k) retirement savings plan is a great tool in your quest for a secure retirement. Of all the retirement accounts available to most investors—401(k)/403(b), Traditional IRA, Roth IRA—the traditional 401(k) has the highest annual elective deferral limit at $18,000 for those under age 50. (You can check out our comparison of these contribution limits).
Using a 401(k) to save for retirement is a lot easier for the average worker since you normally fill out the paperwork when you are first hired at your employer. Many employers automatically enroll their employees in their retirement plan at a 3% contribution rate, although you may want to consider changing the contribution amount. If you’re lucky, your employer may match some of the money you contribute, making it the best investment of all.
In contrast, opening a Traditional IRA or Roth IRA takes some (simple) additional steps. You have to identify a broker to hold your Individual Retirement Account. You have to select some mutual funds to invest in. You have to set up automatic contributions or remember to manually send in your investments every month or at some other interval. Simple steps, but for the new investor the process can be cumbersome. That’s why many choose to stick with a 401(k) plan until they start maxing out the contribution limit.
Do You Have a Roth 401(k)?
What many people do not realize is there are now two types of 401(k)s: the traditional, tax-deferred version and the newer Roth 401(k) version. We’ve told you before that a Roth 401(k) may be the best of both worlds because you get the benefits of a Roth IRA with the ease of use of an employer-sponsored retirement account. (Even better, there are no income limits to participating.)
About 30 percent of employers offer a Roth 401(k) option, but many people are unaware they have a choice. Check with your human resources department to see if you can choose between the two.
New Roth Option? Consider Conversion
The Roth 401(k) was not legislatively written into permanent existence until 2006 with the Pension Protection Act of 2006. (It had existed before then, but was slated to expire at the end of 2010.) With this type of account being still quite new, many firms are just now getting around to offering the Roth as an option.
If you started diligently saving for retirement with your employer’s plan before it offered a Roth 401(k), you may be able to convert your savings to the new option. Even if you can’t convert, you can begin funneling your investments from now on out of each paycheck into a new 401(k) account by either changing your investments online or through your HR department.
How to Convert to a Roth 401k
If you want to convert your Traditional 401(k) to a Roth 401(k), you need to take the following steps. They will also help you think through the process, including the tax ramifications.
1. Check if you can convert.
To start, know that not every company will allow you to convert your existing 401(k) balance to a Roth 401(k). You need to check with your employer to see if this is an even an option. If not, just change your contributions so that new investments go into the new type of account rather than into your original 401(k).
2. Calculate income tax due.
As with IRA conversions, you will owe income tax on the amount you are converting from a tax-deferred investment [Traditional 401(k)] to a post-tax investment [Roth 401(k)]. You may need to speak with an investment advisor to accurately calculate the tax hit you will take in the year of the conversion, but you can estimate on your own. If you are in the 25% marginal tax bracket, just multiply the amount you are converting by 25%.
3. Pay taxes outside of the 401(k) funds.
After you calculate the income tax cost of converting, aim to have those funds set aside separately from the amount you are converting. You don’t want to convert a 401(k) with a $10,000 balance and end up with a Roth 401(k) with a $7,500 balance. Try to pay for the conversion with cash outside of your retirement account.
Remember that you have until you file your taxes to come up with the cash. If you know you’re going to convert in January, you have until April of the following year to save up money. Add a line item to your budget that divides out the total needed by the number of months left until you file your taxes and save for it monthly.
4. Complete the conversion.
Once you have funds lined up to pay for the conversion, take the necessary steps to convert to a 401(k). Your employer or the plan company can provide the specific details on how to convert your account, as it will be different from company to company.
5. Enjoy a tax-free retirement.
That’s it! Continue to contribute to your new Roth 401(k), stash extra money into a Roth IRA if you’re eligible, and enjoy a tax-free retirement.
This article is by Kevin Mulligan, who’s been a senior editor of RothIRA.com. 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.