Benefits of a Roth 401(k) Conversion

A recent study by Willis Towers Watson revealed a new trend among employer sponsored retirement benefits - Roth 401(k)s. In fact, seven out of ten employers now offer Roth 401(k)s to their employees. If you already invest in a traditional 401(k), there's no need to worry. You can convert your existing 401(k) to a Roth and reap the benefits!

What is a Roth 401(k)?

The Roth 401(k) is a workplace retirement savings account that combines the benefits of a 401(k) and Roth IRA. In a traditional 401(k) all contributions are made pre-tax. This means you aren't taxed for income invested in your 401(k). Those taxes will be deferred until you take withdrawals in retirement. With a Roth 401(k) though, contributions are made after tax. This means you pay income tax on the money before investing it, but you won't have to pay any taxes during retirement. Like a traditional 401(k), Roth 401(k)s can be matched by an employer and carry the same contribution limits. It's worth nothing that only your contributions to a Roth 401(k) are made after tax, so any company matching funds in your account will be subject to taxation in retirement.

Benefits of a Conversion

Some employers offer the option to convert an existing traditional 401(k) to a Roth 401(k). By moving funds into a Roth 401(k), your retirement savings can grow and compound tax-free. Since withdrawals aren't taxable, Roth 401(k)s aren't subject to Required Minimum Distributions, or RMDs. This can be especially attractive to people who expect to be in a higher tax bracket during retirement, or plan to work past retirement age. However, the transition will create taxable income. Since your 401(k) was funded with pre-tax money, any conversions will be counted as taxable income when you file your taxes for the year. Unlike a Roth IRA, there are no income limits to participate in a Roth 401(k).

Who Should do a Roth 401(k) Conversion?

Converting all or part of a traditional 401(k) to a Roth 401(k) can be a savvy move for some, especially younger people or those on an upward trajectory in their career. If you believe you will be in a higher tax bracket during retirement than you are now, a conversion will likely save you money. For example, if you're in the 12% tax bracket today you'll pay 12% income tax on any contributions. If you find yourself in a 30% tax bracket during retirement - no worries! You already paid your taxes and can withdraw tax-free. However, the inverse is also true. You can end up costing yourself more money if your retirement tax rate is lower than your rate at the time of conversion.

Another factor to consider is cash on hand. A Roth 401(k) conversion will come with a tax bill and you'll want to use cash on hand to pay it, since using funds from the retirement account will cause you to miss out on compounding investment gains. A Roth conversion usually only makes sense if you have enough money to cover the tax bill. If you don't have the required liquidity, it may make more sense to leave your current 401(k) as is and start funding a new Roth 401(k). Not every employer offers conversions, so you'll need to check with your plan administrator first.

How to Convert

Here is a step-by-step guide to convert a traditional 401(k) to a Roth 401(k):

  • Confirm a Roth 401(k) is offered by your plan administrator.
  • Calculate the tax cost of converting.
  • Set aside enough money to cover the tax bill.
  • Tell your employer or plan administrator you're ready to convert.
  • Follow the steps given by your administrator to complete conversion.

Speak with a Marietta Wealth financial professional to determine if a Roth 401(k) conversion is the right move for you.

The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.

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