A new law expanded the ability to directly convert money in an existing workplace retirement plan to a Roth plan account—provided your plan allows it. That can be good news because there are benefits to saving in a Roth workplace plan like a 401(k), 403(b), or governmental 457(b)—tax-free growth potential and tax-free withdrawals for you and your heirs (as long as certain requirements are met1). Previously, only amounts eligible for rollover distributions could be converted into a Roth account in a plan.
“Investors often forget that a dollar in a tax-deferred retirement account, such as a 401(k), doesn’t equal a dollar of purchasing power. That's because it is taxed when the money is withdrawn,”1 says John Sweeney, executive vice president of Fidelity Viewpoints. “Converting to a Roth account allows you to choose to pay the taxes on your assets at today’s tax rates. Yes, you pay taxes when you convert, but the tradeoff is the potential for years of tax-free growth for you or your heirs.” In addition to the tax benefits, there are several other reasons to consider converting to a Roth account in a workplace plan.
You want to leave money to others.
In many cases, converting to a Roth in a workplace plan has legacy and estate planning benefits. But you need to carefully consider the pros and cons—which can be subtle and complex. Be sure to consult with an estate planning attorney and think carefully before taking any action. For instance, if you’re planning to leave your retirement savings to your heirs, withdrawals from a Roth account generally will not be subject to federal income tax. Your heirs will have to take minimum required distributions (MRDs) on inherited Roth 401(k)s, 403(b)s, and governmental 457(b)s, but they are generally tax free.1
Also, because you pay the income taxes due up front, a Roth workplace plan conversion may also help reduce the size of your taxable estate.
On the other hand, Roth conversions may be disadvantageous to those who intend to leave their assets to charitable institutions, since the charity is already exempt from paying both estate and income taxes on estate-gifted IRAs (effectively, a 0% tax rate upon withdrawal).
You can use tax-free withdrawals strategically.
You’ve already paid the taxes on the money in a Roth account, so as long as you follow the IRS rules, you get to take your money out tax free.1 Mixing how you take withdrawals between your traditional and Roth accounts may allow you to help better manage your overall income tax liability in retirement. You could, for example, limit withdrawals from a non-Roth workplace plan up to the top of a tax bracket and then take necessary funds above that from a Roth account. "This opportunity for tax diversification is one reason why we believe most investors should at least consider having a Roth-type account as part of their overall retirement savings plan," notes Sweeney. And Roth contributions and any earnings from them can generally be rolled over to a Roth IRA, which typically doesn’t require MRDs during your lifetime.
You want to offset new Medicare taxes.
A Roth conversion may potentially help limit your exposure to the new Medicare surtax. That’s because withdrawals from a Roth 401(k), 403(b), or governmental 457(b) don’t count toward the modified adjusted gross income (MAGI) threshold. (A new 3.8% Medicare surtax is levied on the lesser of net investment income or the excess of MAGI above $200,000 for individuals, $250,000 for couples filing jointly.) Depending on your income in retirement, it could be possible that once you’re required to take MRDs, they could expose you to the Medicare surtax, but not if they come from a Roth account. Also, you don’t want the amount you convert to subject you to the Medicare surtax, so be sure to work with a tax adviser when you determine how much to convert.
You expect your tax rates to be higher when you retire.
Tax rates rose for some in 2013. Will they rise in the future? There’s no way to know for certain, but if you think they might, a Roth conversion can make sense.
You have more than five years until retirement.
The longer you have for your savings to grow, the more advantageous a Roth conversion may be in order to offset the upfront cost of converting. Also, the younger you are, the more of a chance your income may be higher when you retire. For instance, if you’re under age 30, it’s likely that your income and spending, even during retirement, will be higher than what it is now, at the beginning of your career. This is the case too if your current income is lower than usual or you expect your future income to increase considerably.
You need to consider a number of important factors before you convert.
Converting to a Roth–type account in your workplace plan does come with a tax cost. You pay the taxes on the amount you convert. "And it is best that you pay the taxes with funds outside the workplace plan, so as not to deplete savings in the account," says Sweeney. In addition, using distributions from qualified accounts results in additional taxes, beyond those incurred by the conversion. And if you’re under 59½, there are usually penalties as well.
Also, you need to ask yourself whether it is a good time for you to convert. It can be if you're in a low tax bracket or your investments have dropped in value due to stock market declines. The lower your current tax bracket, the more assets you may want to convert. The lower the market value of the assets eligible for conversion, the lower the tax liability for converting them.
Also, since a Roth conversion usually increases your taxable income, it could impact your eligibility for tax benefits that are phased out at certain income limits, or push you into a higher tax bracket.
Your plan doesn't offer a Roth
Plans are not required to offer a Roth option. And even if they do, they don't have to allow "in-plan" conversions.
If your plan doesn't offer the Roth contribution feature, and does not adopt the inplan conversion provision, you may still be able to complete a Roth conversion. How? The balances eligible for an in-plan conversion may also be eligible to convert through a direct rollover to a Roth IRA, depending on your age and other considerations. Check with your plan to see what is available and consult your tax adviser.
Is there a benefit to an in-plan conversion vs. a Roth IRA conversion? In general, when choosing between the two options, much of the decision depends on your situation and personal preferences. Among the factors to consider:
- Only amounts eligible for rollover distributions may be converted and rolled over into a Roth IRA. Generally, this is most or all assets in your 401(k), 403(b), or governmental 457(b) if you’re over age 59½.
- Investment options or pricing in your plan compared to those in a Roth IRA.
- Additional creditor protection provided by a workplace plan over an IRA.
- Ability to take a loan against your workplace balance if available in the plan.
- Any other features particular to your plan compared with features available in an IRA.
One key consideration: The new 401(k), 403(b), and governmental 457(b) conversion provision does not let you recharacterize or “undo” a conversion, as you can with Roth IRA conversions. This potential loss of flexibility should be factored into any decision to convert within your plan. This flexibility may be important if your situation unexpectedly changes after you convert (e.g., you no longer have funds to pay the tax cost of conversion). In these cases, recharacterization may allow you to undo a Roth IRA conversion of your assets back to a traditional IRA.
While there are benefits to converting to a Roth account (either in a workplace plan or a Roth IRA), everyone's situation is different. It's important to work with your tax adviser to decide if a conversion makes sense for you.
Also, the ability to convert to a Roth workplace plan may not be immediately available in your plan. The U.S. Treasury has to issue guidelines, and your employer may have to make changes to its plan. Check with your plan sponsor for more information.
- Read Viewpoints: What’s your savings style?
- Converting to a Roth IRA.