Q: My employer offers a Roth 401(k) and I read that I can choose to convert some or all of my existing 401(k) to a Roth. Tax-free retirement income sounds great, but is this a smart idea?
There are certainly some advantages to saving for retirement in a Roth 401(k) as opposed to a typical tax-deferred 401(k) account. Aside from the obvious benefit of tax-free retirement income, Roth 401(k)s generally let you access your contributions at any age without penalty. Plus, unlike a Roth IRA, there's no income limit for contributing to a Roth 401(k).
However, the biggest issue with a Roth 401(k) conversion is taxes. Specifically, the entire amount of your 401(k) that you convert to a Roth will be considered taxable income in the year the conversion takes place.
Even though this can be a large expense, converting can still be a good idea if two things apply.
First, you're in a reasonably low tax bracket now. A Roth 401(k) conversion generally only makes sense if you're in a lower tax bracket now than you think you'll be in after retirement. For instance, if you're in the 10% or 12% tax bracket for 2019, it could be a smart idea to convert some of your account. If you're in the 35% or 37% bracket -- not so much.
Second, I typically only advise Roth 401(k) conversions if you have the money to pay the taxes without tapping into your 401(k) funds. You have until the tax deadline of the following calendar year to pay the tax on a conversion, which gives you time to prepare for this expense.