Does It Make Sense to Convert a Traditional 401k Into a Roth 401k

Today, seven out of 10 companies offer their employees a retirement savings plan. Although they still have the traditional 401(k), they’re now introducing the Roth 401(k). In particular, larger corporations have added Roth options as part of their retirement savings plans.

If your employer offers this, you might question what you’re supposed to do with your traditional 401(k). Before making any decisions, learn as much as you can about this investment opportunity.

Roth 401(k)

A Roth 401(k) is a retirement savings account for the workplace. It’s a combination of a traditional 401(k), which is highly convenient, and a Roth 401(k) that comes with tremendous benefits. Both types of 401(k) accounts have a maximumcontribution of $19,500. Also, employers can match your contributions. However, that’s where the similarities stop.

A big difference is how the government taxes your contributions. Money put into a traditional 401(k) is pre-taxed. In other words, the money you contribute remains tax-deferred until retirement when you make withdrawals.

As for a Roth 401(k), you pay taxes on your contributions before they go into the account. Although you’ll pay a little more upfront, long-term, thismight prove beneficial. That’s becauseyour contribution growth is tax-free. When you decide to withdraw money from a Roth 401(k) as a retiree, you pay nothing in taxes.

Keep in mind that with a Roth 401(k), only your contributions grow tax-free. That means any money your company matches to what you put into the account gets taxed. Even so, this is an outstanding opportunity. In your golden years, you could save hundreds, if not thousands of dollars. Interestingly, only 7 percent of employees contribute to a Roth 401(k).

Converting to a Roth 401(k)

Now comes the question of whether you should convert your traditional 401(k) into a Roth 401(k) or leave it alone. The answer depends on your specific situation. It could be an awesome idea, but then again, it might not serve you well.

The biggest drawback of a conversion like this is the taxes you’d have to pay. Since the government hasn’t yet taxed the money in your traditional 401(k), you’d have to pay what’s due before you can make the conversion to a Roth 401(k). Depending on how much money you’ve contributed, that could equate to a huge financial hit.

For instance, if you have $100,000 in a traditional 401(k) account but want to convert to a Roth 401(k), and if you’re in the 22 percent bracket, you’d have to fork over $22,000 in taxes. So, if you decide to make the conversion, be sure you have the cash available to pay the taxes on what you have in your traditional 401(k) account.

What you don’t want to do is use money from the investment to pay the taxes. Here’s why. Not only would you lose more than $22,000 (using the scenario outlined above), but you’d also miss out on years of compound interest. In most cases, that’s roughly 10 percent. After 30 years, your $100,000 could easily grow to $436,000 due to compound interest.

An important note is to consider other 401(k) conversions. Let’s say you decided to leave the money in your traditional account alone. Instead, you start making contributions to a Roth 401(k) using money from your paychecks. As a result, you won’t get hit with a big tax payment, yet you can still benefit from the Roth 401(k) tax-free growth later on.

Before making a decision you will either want to consult a financial planner or find a good retirement planning application to help you figure out if this type of conversion makes sense. There aren’t very many consumer financial planning applications powerful enough for this type of analysis. But the WealthTrace Planner has a Roth Conversion Scenarios section set up just for this type of analysis and it is very detailed. It even shows you year by year how much you will save or lose in taxes. You can also go with something like Schwab Intelligent Portfolios and get a hybrid model, where you can have access to their retirement planning tools and have access to a financial planner.

Making the Conversion

If you want to convert your traditional 401(k) to a Roth 401(k), start by determining if this is even an option. According to the IRS, only vested money works for this, meaning it’s owned solely by you. Any contributions from your employer are also vested but over time. Based on the vesting schedule established by your employer and your length of employment, there’s a chance the money in your traditional 401(k) isn’t fully vested, at least not yet.

Next, you’ll need to determine what you’d owe in taxes. For this, multiply the amount of money you want to convert by your income tax rate. You’ll then need to figure out how to come up with that amount of money. Remember, you want to pay taxes in cash rather than using money from the 401(k) account.

You’ll want to talk to someone in the HR department about the process of converting a traditional 401(k) into a Roth 401(k). A representative can provide you with all the necessary information and documentation to get started.

What About the Traditional 401(k) Account?

Whether you have one or several traditional 401(k) accounts, you can convert them into a single Roth 401(k). However, you have to remember the taxes due. If that makes you nervous, you can always convert your traditional 401(k) into a traditional IRA. That’ll give you better control of your finances and allow you to choose from thousands of different funds. Best of all, there aren’t any tax consequences.

If you like the idea of a Roth IRA, remember you have to pay taxes on the amount you roll into it. However, with incredible tax-free growth and withdrawals during retirement, this is a great option as well.

Talk to an Expert If You Can’t Do It Yourself

When it comes to converting a traditional 401(k) into a Roth 401(k), you have some important decisions to make. Although this and a Roth IRA are outstanding possibilities to save for your retirement, if you cannot run the conversion scenarios yourself,it’s best to talk to a financial advisor before making your next step.

Leave a Comment

CommentLuv badge

This site uses Akismet to reduce spam. Learn how your comment data is processed.