Be sure you understand the tax impact of a 401(k) conversion

Quick Summary

  • Many companies have added a Roth option to their 401(k) plans.
  • Traditional 401(k)s and Roth 401(k)s are taxed differently.
  • If you convert to a Roth 401(k), you’ll owe taxes on the money.

If you started diligently saving for retirement with your employer’s 401(k) plan, you may be able to convert your savings to a Roth 401(k). Here’s how.

401(k)s vs. Roth 401(k)s

There are two types of 401(k)s: The traditional, tax-deferred version and the newer Roth 401(k) version.

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. For 2019, that’s $18,000 if you’re under age 50. People who are older than 50 can add an extra $6,000 catch-up contribution.

If you’re lucky, your employer will match some of the money you contribute.

A Roth 401(k) offers the ease of use of an employer-sponsored retirement account with the benefits of a Roth IRA. And unlike a Roth IRA, there are no income limits for participating in a Roth 401(k).

The biggest difference between a traditional 401(k) and a Roth 401(k) is when you get the tax break. With a traditional 401(k), you can deduct your contributions, which lowers your taxable income for that year. With a Roth 401(k), you don’t get an upfront tax break, but your money grows tax-free.  Once you put money into a Roth, you’re done paying taxes on it.

Another perk: Roth 401(k)s offer more flexibility in terms of withdrawals. You’ll pay a 10% early withdrawal penalty to access money from your 401(k) before age 59 1/2, unless you qualify for an exception. With a Roth 401(k), you can withdraw your contributions at any time, for any reason, without taxes or penalties.

Should You Convert to a Roth 401(k)?

If your company offers a Roth 401(k), you should consider two factors before making any decisions:

  1. Do you think you’ll be in a higher tax bracket during retirement than you are now? If so, that’s a good reason to switch to the Roth. You’ll pay taxes now at a lower tax rate, and then enjoy tax-free growth and income later when your tax rate is higher. But keep reading before you decide:
  2. Do you have the cash to pay taxes on the conversion? You’ll pay income taxes on any money you convert. If you move $100,000 into a Roth 401(k), and you’re in the 22% tax bracket, you’ll owe $22,000 in taxes. Make sure you have the cash to cover the tax bill. Don’t use money from your 401(k) to pay the taxes. If you do, you’ll miss out on years of compounding. And that will end up costing you a lot more than $22,000.

How to Convert to a Roth 401k

If you’ve decided a conversion makes good financial sense, here’s a general overview of the process.

1. Check if you can convert.

Not every company allows employees to convert an existing 401(k) balance to a Roth 401(k). You need to check with your employer to see if this is 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’ll owe income tax on the amount you’re converting from a tax-deferred investment—your traditional 401(k)—to a Roth (401(k), a post-tax investment. You may need to speak with an investment advisor to accurately calculate the tax hit you’ll take in the year of the conversion, but you can estimate on your own. If you’re in the 22% tax bracket, just multiply the amount you’re converting by 22%.

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’re converting. You don’t want to convert a 401(k) with a $100,000 balance and end up with a Roth 401(k) with a $78,000 balance. 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 the 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.



Compare Popular IRA Providers