Converting a 401(k) to a Roth 401 (k)
Q. I’ve heard I can convert my traditional 401(k) to a Roth 401(k). Is that true?
— Loving tax-free savings
A. It depends on the plan offered by your employer.
Prior to 2013, you couldn’t convert an existing taxable 401(k) plan to a Roth 401(k) plan. In 2013, the government changed the law. With the changes, employers could, if they wanted, offer both a regular 401(k) and a Roth 401(k), said Bernie Kiely, a certified financial planner and certified public accountant with Kiely Capital Management in Morristown.
Before you consider a conversion, let’s make sure you understand the differences between the plans and what impact a conversion would have on your tax situation.
With a regular 401(k) plan, you are making pre-tax contributions.
“Pre-tax means you aren’t paying federal or state income tax on the monies you contribute to the plan,” Kiely said. “The downside of pre-tax contributions is when you ultimately withdraw the funds in retirement, you must pay federal and state taxes on the entire distribution.”
When you contribute funds into a Roth 401(k) plan, you are contributing money that you have already paid federal and state income taxes on.
If you want to contribute $1 to the plan, you must earn approximately $1.33 — 33 cents to the government and $1 for the plan, Kiely said.
“The benefit of a Roth 401(k) plan is all the money you ultimately take out is entirely tax free, including all the untaxed earnings that have accumulated over time,” he said.
If your employer chooses to offer a Roth 401(k) plan, you have a choice when you make new contributions. You could even contribute money to both, Kiely said, noting the younger you are, the more a Roth 401(k) plan makes sense.
You may also have a choice for the contributions you’ve already made.
If your employer allows, you can turn your pre-tax 401(k) plan into a Roth 401(k) plan. You do this by an in-plan Roth conversion, also known as an in-plan Roth rollover, Kiely said.
“If you do an in-plan conversion, your 401(k) balance gets transferred into the Roth 401(k) plan,” Kiely said. “But by doing so, you will have to pay federal and state income taxes on all your previously untaxed contributions.”
Do the tax calculations first because the amount of taxes you will have to pay could be substantial.
Generally speaking, Roth accounts make sense if you expect to be in a higher tax bracket when you need the money after age 59 1/2, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton. If that’s the case, converting now and paying less tax than you would have in the future can save you taxes.
Start by considering the marginal tax rate you would be paying upon conversion.
“Adding income in the year of conversion could push you into a higher tax bracket, lessening the future tax savings,” Hook said. “Higher taxable income could also cause some of your itemized deductions to be reduced or phased out since certain deductions are reduced when Adjusted Gross Income reaches a certain amount.”
Also, Hook said, other taxes kick in at higher income levels, such as the 20 percent long-term capital gains rate and the 3.8 percent net investment income tax.
“A Roth conversion that results in lower itemized deductions and higher capital gains and investment income tax could make the Roth conversion much more expensive than you think,” Hook said.
Before converting, you should figure out where you are going to get the money to pay the additional tax.
Hook said the money should come from outside of your 401(k) and other retirement accounts.
“Paying it from an IRA account will create more tax and if you are under 59 1/2 will result in a 10 percent early withdrawal penalty,” Hook said. “If you want to take an extra distribution from your 401(k) to pay the tax, that will also be subject to tax — assuming the plan allows in-service withdrawals at all — and may also be subject to the 10 percent early withdrawal penalty.”
He said the best place to take money from to pay the tax would be a checking or savings account. Selling a security in your brokerage account may be another option, especially if that security may be worth less than what you originally paid for it.
A sale would result in a taxable loss which could be used to offset other gains — up to $3,000 against ordinary income, Hook said.
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Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.