On September 27, President Obama signed the Small Business Jobs Act of 2010, which includes a provision that allows a 401k plan to offer plan participants the ability to convert their traditional 401k accounts to a Roth 401k. Is this a good idea? While there's a lot of buzz these days about Roth 401k conversions, there are rules and considerations which limit the situations where it might work for you, starting with the fact that you generally need to be at least 59-1/2 years old to be eligible to do it. But let's take a closer look.
For this to be a possibility for you, your employer's 401k plan must have a Roth 401k feature, and your employer must amend its plan to allow for the conversion of your traditional 401k accounts to a Roth account. As mentioned in my previous post, about 29 percent of 401k plans offered a Roth feature in 2009, with 25 percent more expected to add this feature in 2010. If you're interested in converting your traditional 401k account to a Roth account, your first homework item is to ask your employer or plan administrator if the Roth 401k feature is available to you and if you're allowed to convert.
Your second homework item is to understand the basic differences between a traditional 401k account and a Roth 401k account, and their relative advantages and disadvantages. The considerations are similar to whether you should invest current and future contributions in a Roth 401k, as I've written about previously.
It's important to remember that you can only convert amounts in your 401k plan that would otherwise be eligible for a rollover distribution. That usually means you must have reached age 59-1/2 if you're still working for the employer, or if you've terminated employment but have left your money in your former employer's 401k plan. Not all your accounts are eligible for conversion; you can only convert your own contributions and certain types of employer matching contributions. It's possible that your plan may provide other employer contributions that could be converted before age 59-1/2. If you're interested in the Roth 401k conversion, your third homework item is to ask your plan administrator which amounts are eligible for conversion.
If you're offered a Roth conversion, here are two things to consider:
- You'll need to pay federal and state income taxes on the amount you convert from a traditional 401k to a Roth 401k. In most cases, you'll want a source of money outside your 401k plan to pay the additional income taxes. If you don't have this source of funds, then a Roth 401k conversion might not be for you.
- For Roth 401k conversions in 2010, you can elect to pay income taxes on the conversion in 2010, or you can elect to spread the taxes over 2011 and 2012. This allows some flexibility in your tax planning, if you think your marginal income tax rates will change during the next few years.
- You believe that income tax rates will be higher when you retire compared to today. While many people think this will happen if federal and state governments raise tax rates to meet their substantial deficits, your income tax rate might not increase in retirement, as I've written about previously.
- You can avoid required minimum distributions (RMD) at age 70-1/2 with Roth 401k accounts, while RMDs apply to a traditional 401k. Technically the RMD applies to Roth 401k accounts, but you can get around this by rolling your Roth 401k into a Roth IRA, which doesn't have the RMD. The lack of an RMD might come in handy if you're working in your seventies, as I've advocated previously, since your retirement savings can continue to enjoy tax protection. It also might be a good idea if you plan to live on just the interest and dividends for retirement income and pass along the principal to your heirs.
- You believe your traditional 401k accounts are depressed in value due to the stock market decline but will appreciate significantly by retirement. If this is the case, you'll pay taxes on this lower depressed value, and you'll avoid taxation on the subsequent appreciation.
- You'll be increasing the amount of your tax sheltered retirement savings, in effect, if you pay for the additional income taxes with money outside your 401k plan. I'll illustrate this in my next post on this subject.
As you can see, there can be several moving parts in this analysis. If you don't have a crystal ball on where income tax rates will be when you retire, whether your depressed asset values will come roaring back, or whether the required minimum distributions will apply to you at age 70-1/2, then you might consider a form of tax diversification. You can convert just part of your 401k account to a Roth and leave the remainder in your traditional 401k. This could also help your cash flow, since you'll reduce the amount of income taxes you'll have to pay on the conversion amount.
Look for my next post on this subject in a few days, where I'll do the math to show how a Roth 401k conversion might increase the amount of money you'll have to spend in retirement.
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