For decades, 401(k) plans have helped workers prepare for retirement. But Roth 401(k)s are a much newer concept that many workers couldn't take full advantage of. Now, though, the recent resolution of the fiscal cliff debate included a provision that allows many workers to convert 401(k) plan accounts to Roth 401(k)s for the first time ever.
But just because you can convert your 401(k) to a Roth doesn't mean that it's always the right move. Let's take a look at how the two types of plans work and which one makes more sense for different types of investors.
To Roth or not to Roth?
Traditional 401(k)s are simple retirement plans that essentially allow you to defer income until you retire. When you put money into a 401(k) account by having money withheld from your paycheck, you don't have to pay income tax on that income in the year in which you earn it. Instead, when you decide to withdraw money from your 401(k) after you retire, you have to include your withdrawal as taxable income at that point in the future. That gives you the potential to defer the taxes on your money for decades, letting it grow larger than it would if it were subject to immediate tax.
On the other hand, Roth 401(k)s work differently. If you make a Roth 401(k) contribution, you don't get the immediate tax break of having your taxable income reduced by the contributed amount. Instead, you use after-tax money to make your contribution, but in exchange, you don't have to pay income tax on the money when you withdraw it from your Roth 401(k) at retirement.
Changing your mind
Under old law, it was very difficult to take money you had contributed to a traditional 401(k) and move it into a Roth 401(k). Unlike IRAs, for which anyone can easily convert from a traditional account to Roth, 401(k)s required workers to have what was known as "distributable funds" in order to convert. For practical purposes, that meant that unless you were age 59 1/2 or above, you probably wouldn't have been able to convert.
Now, though, anyone who has a 401(k) plan that offers a Roth option is allowed to do a conversion. From a logistical standpoint, the conversion is simple: Your money never leaves the plan, and you don't have to do anything except fill out some paperwork with your HR department.
The tax effects when you convert 401(k) balances to a Roth 401(k) can be extreme if you're not prepared for them, though. Moving money from a traditional 401(k) to a Roth 401(k) increases your taxable income in the year of the conversion. You won't pay any penalty for making the conversion, but you will end up owing more in income tax in most cases, with the amount of additional tax depending on what tax bracket you're in.
Is a Roth conversion smart?
In considering such a big financial decision, you'd hope that there'd be solid guidance on whether converting was a good idea or not. Unfortunately, there are so many variables involved that it's tough to give general advice, but here are some factors to keep in mind.
- If you're in a lower tax bracket now than you expect to be when you retire, converting is generally a good idea. If you expect your taxes to be lower in retirement, you might be better off keeping your traditional IRA -- although the uncertainty of future tax rates will never go away.
- If you already have Roth IRA accounts, you may not need a Roth 401(k) as much. Diversifying your tax exposure is as important as diversifying your investments.
- Be careful about conversions if you don't have money outside the account to pay increased taxes. If you have to withdraw 401(k) money early to pay those taxes, you'll incur penalties -- generally not a good move.
Think about it
With relatively few employers offering Roth 401(k) options, you may not even have the chance to convert 401(k) money to a Roth. But if you do have the opportunity, take a closer look, because taking advantage could save you a bundle in taxes in the long run.
Fool contributor Dan Caplinger appreciates your comments. You can follow him on Twitter @DanCaplinger. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.