Taxes are generally unavoidable. But when it comes to your retirement savings, you have a choice as to when you want to pay them. Now, or later?
When you make pre-tax contributions to a traditional 401(k) plan, you’re choosing the “pay later” option. Your contributions and any earnings on those contributions grow tax-deferred. That means you don’t pay taxes until you withdraw the money. A pre-tax savings strategy tends to work for people in higher tax brackets because they may benefit from getting an immediate tax break. It can also be helpful if you expect to be in a lower tax bracket when you move into retirement.
Roth 401(k)s flip that around. You pay taxes on Roth 401(k) contributions before they get deposited into your account. Once you meet certain qualifications, your contributions plus any earnings can be withdrawn tax-free. Roth 401(k) accounts are attractive for people in the early part of their career, when earnings (and therefore tax rates) are generally at their lowest point.
Roth 401(k) accounts have been around since 2006. But until recently, it was relatively rare for employers to offer them. A 2015 study found that 58% of employers offered a Roth 401(k), up from just 11% back in 2007.1
If your employer offers the Roth 401(k) option, you can make your own “now or later” tax decision. And if your employer is among the 33%2 that allow Roth 401(k) in-plan conversions, you can decide if it makes sense to move all or a portion of your current 401(k) balance into a Roth 401(k).
Is a Roth 401(k) right for me?
Choosing between a traditional or Roth 401(k) mostly hinges on your current and future tax rate. If you expect that your tax rate is going to be higher in retirement, consider the Roth 401(k). If you think that your tax rate will be lower in retirement, consider a traditional pre-tax 401(k). The challenge with this choice is that it’s hard to predict what your future tax rate will be.
Fortunately, it doesn’t have to be an either/or decision. Many people choose to be tax-diversified by funding both types of accounts. This gives you tax planning flexibility today and in the future.
Roth 401(k) conversion considerations.
If you decide a Roth 401(k) is a good fit, converting a portion of your regular 401(k) account balance can jump-start your Roth strategy. Here’s how to do it:
- See if you can. Check with your HR department or plan administrator to see if a Roth 401(k) in-plan conversion is allowed.
- Calculate taxes. You’ll need to pay income taxes on the entire conversion amount in the year of the conversion. If you’re converting a large sum, this could push you into a higher tax bracket and create a large one-time tax liability. You may need to work with a tax professional to calculate just how much money you’ll owe. And this may influence how much you convert, so look at the tax implications of multiple scenarios.
- Finance your conversion. Unlike a straight distribution from your retirement account, taxes are not automatically withheld when you do an in-plan Roth 401(k) conversion. This means that you’ll need to have a plan in place to pay those taxes from a source outside of your retirement account. Taxes aren’t due until you file your return in April of the year after you do your conversion. So if you convert in January, you’ll have months to set aside money for your conversion tax bill. You don’t want to use up all your available cash just to cover the taxes. So be realistic about what you can afford.
- Convert. Each 401(k) plan may have different conversion procedures and requirements. Be sure you understand and follow the rules for your plan.
To summarize, consider a Roth 401(k) conversion if you:
- Know your plan allows it.
- Think your tax rate will be higher in retirement than it is now.
- Are still many years away from retirement.
- Want the flexibility of tax-free income in retirement.
- Have the ability to pay the conversion taxes from money outside of your 401(k).
A Roth 401(k) conversion can be a good move for some. But it’s a complex decision with several moving pieces. Understand your options, plan ahead, and consider working with a tax or financial professional to help decide if it’s right for you.