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

Due to a Congressional budget deal, Roth retirement account lovers now have the option to convert their 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 401Ks are not taxable until withdrawals or distributions).

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

Roth 401K Benefits

Roth 401Ks, like Roth IRAs, 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 401Ks to their superior Roth 401K counterparts!

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

Roth 401K Conversion Availability

The Roth 401K option has grown rapidly in popularity since its first release in 2006. 86% of employers now offer a Roth 401K option. In order to convert a Traditional 401K to a Roth 401K, your employer must be one of them.

Roth 401K conversion

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 26% of employees offered a Roth 401K option actually contribute to one.

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 24% 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 $48K. 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 401Ks 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 & contributed to a Traditional 401KPre-Taxed & contributed to a Traditional 401K
Maximum Annual Individual Contribution$20,500 (2022)$20,500 (2022)
Catch-up Contribution for those age 50+$6,500 (2022)$6,500 (2022)
Can Roll-Over toRoth IRA or new employer's 401KAnother pre-tax 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?

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