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Roth 401K Conversions: Now that They’re Here, Should you Make the Switch?

Last updated by on January 1, 2016

The fiscal cliff deal brought a huge influx of noteworthy personal finance news.

One of the lesser publicized changes is pretty big for Roth retirement account lovers: you now have the option to convert your Traditional 401K to a Roth 401K, at any age.

Oddly, this was part of the sequestering of spending cuts. Congress decided to permit the Roth 401K conversions in order to raise additional revenue now (as Traditional 401K’s are not taxable until withdrawals or distributions).

Should you switch to a Roth 401K? Let’s Take a Look

Roth 401K Benefits

Roth 401K’s, like Roth IRA’s, permit tax-free growth and distributions in retirement.

This means that when your retirement pensions are in the millions and bloated, you’ll be able to get tax-free income instead of paying higher income taxes.

And in the unlikely event you die? Tax-free inheritance for your heirs!

The benefits are clear. So let’s all switch our Traditional 401K’s to their superior Roth 401K counterparts!

Actually… it’s not quite that easy or straight-forward.

Roth 401K Conversion Availability

roth 401k conversionThe Roth 401K option has grown rapidly in popularity since its first release in 2006.

However, it’s still so new that only about 49% of employers offer a Roth 401K option, according to the Plan Sponsor Council of America (PSCA).

In order to convert a Traditional 401K to a Roth 401K, yours must be one of them.

From there, your employer must actually decide that they want to amend their retirement plan offering to allow for the conversions. Knowing how slow benefits departments can be, this might take some time.

If your employer is allowing Roth 401K conversions, you’re just some simple paperwork or clicks away from being able to do so. You’ll have to check with them on the specifics.

Roth 401K Conversion Tax Implications

Only about 17.4% of employees offered a Roth 401K option actually have one, according to the PSCA.

I assume there are two big contributing factors to this:

  1. lack of awareness that they exist
  2. lack of knowledge about what they are & their benefits

There’s also a third big factor: tax implications.

As with a Roth IRA, any contributions you make to a Roth 401K are taxable in the year that you make them. You are effectively taxed now, vs. in retirement.

I’ll save the strategic and philosophical implications of being taxed now vs. in retirement for an upcoming post, but it’s important for you to understand that a Roth 401K conversion could have immense tax implications for you in the immediate future.

For example, if you’re in the 28% tax bracket, have a $200K Traditional 401K balance, and decide to convert all of it over to a Roth 401K, it could leave you with an added tax bill of $56K. And it may even push you up a tax bracket or two. Why? The full amount you convert is considered taxable income for the calendar year you convert it.

How are you going to pay for all of that? It’s going to have to be out of pocket. So you’ll want to make sure you’ll have enough cash on hand to cover the conversion when tax time rolls around.

With the tax implications, my guess is that most Roth 401K conversions will be done by those with small Traditional 401K balances or the very wealthy, who have hundreds of thousands to cover a huge tax bill.

How do Roth 401K’s Differ from Traditional?

One big thing to note is that even if you complete a Roth 401K conversion, you’ll still have a Traditional 401K for your employer’s 401K match. Any matching funds are pre-tax, not post-tax like a Roth. You could later convert those matching funds, but you’d still need the account to be able to accept them.

Your maximum 401K contribution and your employer’s maximum 401K contribution match are still the same.

To understand the other difference between a Traditional 401K and Roth 401K, check out this chart:

Roth 401KTraditional 401K
Contributions ArePost-TaxPre-Tax
Can be Started By
Employer onlyEmployer only
Matching Funds ArePre-Taxed in a Traditional 401KPre-Taxed in a Traditional 401K
Maximum Annual Individual Contribution (2013)$18,000 (2016)$18,000 (2016)
Catch-up Contribution for those over 50$6,000 (2016)$6,000 (2016)
Can Roll-Over toRoth IRA or new employer's 401KTraditional IRA, a new employer's Traditional 401K, or a Roth IRA (pay taxes)
Pay Taxes AtTime of ContributionWithdrawal in Retirement
Can Begin Withdrawing Earnings Without PenaltyAt age 59.5At age 59.5
Taxes in AccountNo taxes on dividends, capital gains, or interestNo taxes on dividends, capital gains, or interest

Roth 401K Conversion Discussion:

  • What do you think about the Roth 401K conversion?
  • Are you going to covert? Why or why not?

About the Author
I am G.E. Miller, & this is my story. My goal is financial independence ASAP. If you share that goal, join me & 10,000+ others by getting FREE email updates. You can also explore every post I have written, in order.

  • Mike says:

    My employer started the Roth option in 2012, but for now I’ve still got my mind set on not converting to a Roth option.

    I have a Roth IRA which helps to defer some of the tax bill, and I really have no idea what the tax rates will be when I retire in 30 years, so I want to have some in a traditional retirement account and some more in a Roth retirement account. When retirement comes around I’ll be able to have a choice on which account to withdrawal from based on my income tax rates.

    Either way, the most important part is to save something for retirement. Traditional or Roth, if you’re contributing something, it’s better than doing nothing at all.

  • Awesome writeup. My employer just started allowing us to direct deposit into a Roth, but I already have one that I have been using, so I didn’t sign up.

  • Brendan says:

    I’m confused about the last part of that chart. It says “no taxes on dividends, capital gains, or interest.” Am I to assume that means I’m only taxed on my (and my employer’s) contributions? Obviously this would only come into play with a traditional 401k, as with a Roth you would have paid taxes before you incurred any capital gains. Here’s a simple hypothetical:

    I contribute $100,000 into a traditional 401k. The funds I invest in earn 5%, so my balance is $105,000. When I make withdrawals, am I only taxed for that original $100,000 investment?

  • Kirby says:

    This was indeed an interesting part that was added to the recent tax reform.

    Like you said in your post, this is likely to take quite a bit of time with benefits departments – especially since a number of firms do not even currently have a Roth 401(k) feature. Just because you are allowed to do it from a tax law perspective doesn’t mean you will actually be able to take advantage of it! Let’s hope this kick starts some firms to start offering a Roth 401(k), so more people can take advantage of the great tools.

  • George P Burdell says:

    I don’t plan on converting to or using a Roth 401k. Here are my reasons:

    1) Maxing out a regular 401k puts me in a lower tax bracket

    2) I have a pretty significant balance in my 401k; that’s alot of taxes to pay if I convert.

    3) I max out a Roth IRA, so that’s already tax free for retirement. The regular 401k lowers my taxes now. So I’ve got the best of both.

    4) Who knows what tax rates will be in the future. If you were 100% you would be paying a higher rate, then a Roth would be better.

    One more thing to think about. When you retire and start making withdrawals, that amount may be significantly less than your pre-retirement income. That alone could mean a lower tax bracket/rate than you’re paying now. In that case, a Roth isn’t the better choice.

    Also, I think the govt likes the Roth because they get paid today versus decades from now.

    • Joe $hmoe says:

      I too have your similar situation, except I max out to 50K/yr in 401K total contribution (pre-tax + company match + post-tax)

      1. I max out on regular 401K to lower my tax, $17k/yr. Company matching, a few more thousand. The bigger half of my $50K/yr 401K limit goes into after tax 401K, $30K/yr.

      2. I have a significant amount in my 401K but most of it is post-tax 401K.

      3. I’m ineligible for IRA or Roth IRA because of my income being too high. Thinking about starting a HSA (health savings account) this year for tax reasons.

      4. Who know the future, but looking at the current government, QE and inflation, it looks like its a greater than 50% chance that tax rates will go up.

      When I retire (early 40’s), I’ll convert my post-tax 401K to Roth IRA. This is only worth it if:
      1. I am at a lower tax bracket during the year of conversion vs. future withdrawal year @ age 59.5 .
      2. I think future withdrawal year will have me be in a higher tax bracket due to future tax laws.

      The tax will not be that bad since I already paid tax on a post-tax 401K contribution. I will pay tax on the earnings of my post-tax contributions only.

      To lower my tax bracket when I convert, I plan to live overseas for a year to qualify for foreign resident exclusion. That’s a 90K+ deduction from your federal income tax. I may not have to pay any tax on the conversion.

    • Joe Reeves says:

      You don’t have to convert the whole pre-tax 401k. You can convert a partial amount, perhaps an amount up to the ceiling on your current tax bracket. Lots of variables go into the decision, its tricky.

  • Kristen says:

    Well written article. Question– didnt this become an option in 2010? Was it just for that year or did it just get extended this year?

  • Janet says:

    Do I understand correctly that even if funds are converted from a 401k to a Roth 401k, that future employee and employer contributions will not go into the Roth 401k, but rather into the original 401k? If so, why is that?

  • Kevin says:

    During the process of converting from 401k to Roth 401k, is the amount taxed as “long term capital gains” or it is all taxed at the income tax rate?

    • J.R. says:

      You should check with a CPA, but I’m 99% sure it’s taxed as ordinary income, and thus at your standard income tax rates.

      Since there are a lot of young savers here, a word of caution. There is no reason to pay any significant mark-up to invest. If your 401K offers only load funds, and especially if the company is a mid-size to small company, you may be better off investing outside of your 401K, using an IRA and investing in taxable accounts… for my wife’s prior 401K I found that a taxable account was actually a better deal, even when I assumed the 401K funds would outperform by 1%. We contributed just enough to get the match, and did our savings elsewhere.

      • J.R. says:

        I forgot to mention – I found 18 fees of various types when reading the prospectus – about 5 of which would have a serious impact on us, one way or another. The matching was all that made this particular vehicle worth considering.

    • Joe Reeves says:

      It’s taxed at ordinary income tax rates. It could make sense to convert an amount that brings you up to the ceiling of your current bracket. You don’t have to do a 100% conversion.

  • Sparky says:

    My employer now offers Roth 401Ks, but for future deposits only. So my deposits now go into the new Roth 401k.

    I asked and I was not allowed to convert my existing Traditional 401k to the new Roth 401k! Maybe that’s just as well as the employer’s match has to go into a traditional 401k.

  • Darrell says:

    I did the calculations, and the only way it makes sense to convert a traditional 401(k) to a Roth is if the tax rate will be higher in retirement, which is highly unlikely due to age and reduced income. While the money in the Roth grows tax-free, the fact that you have to pay tax upfront limits the amount of money you would have to invest. So, it’s either pay the IRS now and invest the rest in a Roth, or put their part in the traditional 401(k) and let their part grow with your part, which is the taxes you pay when taking the money out.

    For example, if you can only afford $10,000 a year to invest, and you were at a 25% tax rate, you could invest all $10,000 in a traditional 401(k) and let it grow, and then pay the taxes. In retirement, taxes should be lower because of age and reduced income. So, if you were in a 18% tax bracket in retirement, and your money tripled in your 401(k), you would be paying $5,400 in taxes, and have $24,600 to spend.

    If instead you chose to invest the $10,000 in a Roth 401(k), you would have to pay 25% taxes up front, which would leave you with $7,500 to invest. If you were in the 18% tax bracket in retirement, and your money tripled in your 401(k), you would owe no taxes but you would only have $22,500 to spend.

    So, as the example above illustrates, unless the tax rate at retirement is higher, which is unlikely, the traditional 401(k) should be a better choice if you have a limited amount to invest each year.

    However, one of the hidden advantages of a Roth 401(k) is that it does allow you to invest more of your income into a 401(k) now, if you can afford to do so, without exceeding the IRS contribution limits, since you are taking care of the taxes outside of the contribution. So you could invest the full $17,500 IRS limit post-tax, and pay the $4-5,000 in taxes outside of the 401(k). The full $17,500, plus any earnings, would be yours at retirement. If you instead invested the $17,500 into a traditional 401(k), without paying the taxes upfront, then you would be actually contributing a smaller portion for yourself, because a portion of that amount will be going to the IRS during retirement.

  • Dennis says:

    I just became disabled and will have limited taxable income. Since a Roth is taxed as income can I convert part of my 401k to a Roth each year equal to my considerable deductions (kids, mortgages, etc.)therefore creating a tax free conversion to the Roth?

    Thank you


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