How to Convert a 401(k) To a Roth 401(k)

A 401(k) is one of the most common retirement savings tools in America today. But, there are many types of 401(k) accounts, including traditional and Roth 401(k)s. A traditional tax-deferred 401(k) allows you to contribute pre-tax dollars, which are taxed upon withdrawal. On the other hand, Roth 401(k) contributions are made with post-tax dollars in the hope of locking in tax-free qualified withdrawals in retirement.

Combining some of the best features of a 401(k) with a Roth IRA, the Roth 401(k) can be an attractive investment vehicle, and it’s possible to convert your 401(k) funds into a Roth account. This conversion may be a potentially beneficial maneuver that could result in tax-free retirement income and bring additional tax benefits down the road.

This article will explore the differences between a 401(k) and a Roth 401(k), the conversion process, and why it might be worth considering.

Understanding the Difference Between a 401(k) and Roth 401(k)

Before diving into the conversion process, it’s essential to understand the differences between a traditional 401(k) and a Roth 401(k), including the tax implications, withdrawal rules, and contribution limits for each.

Tax Implications

The main difference between a traditional 401(k) and a Roth 401(k) lies in the tax implications. With a traditional 401(k)—like a traditional IRA—contributions are made pre-tax and grow tax-free until retirement. This means they reduce your gross income and, in turn, your income tax (and potentially your tax bracket) for that year. However, when it comes time to retire and start making withdrawals on your retirement savings, those distributions are subject to income tax at your highest tax rate.

Conversely, Roth 401(k) contributions are made with after-tax dollars. While you pay taxes upfront, you reap the benefits down the line with tax-free withdrawals (qualified distributions) in retirement. This is one of the main benefits of a Roth account. If you anticipate being in a higher tax bracket during retirement, a Roth 401(k) could offer significant tax benefits in reducing your lifetime liability.

Withdrawal Rules

Understanding the withdrawal rules for both types of plans can significantly impact your retirement income strategy. With traditional 401(k) plans, the IRS mandates Required Minimum Distributions (RMDs) from age 73 onwards, as of 2023. Early withdrawals before age 59 1/2 are subject to a 10% penalty plus ordinary income tax.

Roth 401(k)s offer a bit more flexibility. While you still can’t touch the money before age 59 1/2 without facing penalties, beginning in 2024, Roth 401(k)s aren’t subject to RMDs. This means your money can continue to grow tax-advantaged for longer.

Contribution Limits

Both traditional 401(k) and Roth 401(k) plans have annual contribution limits. For 2023, the maximum amount an individual can contribute is $22,500, with an additional $7,500 catch-up contribution allowed for those 50 or older.

While income limits apply to a Roth IRA, there are no income limits for a Roth 401(k) or a traditional 401(k).

The Conversion Process: Step-by-Step Guide

Converting a 401(k) to a Roth 401(k) requires careful planning and attention to detail. Follow this step-by-step guide to ensure a smooth conversion process.

Determine Eligibility

First, determine whether you are eligible to convert your 401(k) to a Roth 401(k), as not all retirement plans allow for in-plan conversions. If you’re eligible to convert your 401(k) to a Roth 401(k), there’s a fair amount of flexibility.

There are no income limits or restrictions for converting, but you should consider your current tax bracket, taxable income, future tax rates, and time horizon until retirement to determine if a Roth account suits your personal finances.

Remember that the five-year rule applies to distributions from Roth accounts, so you shouldn’t execute a Roth conversion if you are planning to need your retirement savings in the next five years. In other words, you’ll need to have your converted Roth funds in the account for at least five years to access the earnings portion tax-free.

Note that a 401(k) to Roth 401(k) conversion is similar to a Roth IRA conversion, but the two processes are not the same.

Calculate the Tax Impact

Before you make any moves, it’s essential to understand the tax implications. Converting a 401(k) to a Roth 401(k) results in a tax bill, as the converted amount will be treated as taxable income for the year of conversion.

Depending on the size of your 401(k), this could potentially push you into a higher tax bracket, increasing your income tax rate and affecting the refund you’d normally receive after you file your tax return.

You should consult with a tax advisor to weigh the short-term tax liability against the potential for tax-free growth and tax-free withdrawals in retirement. The reality is that making timely tax payments will be a crucial part of the process — at one point or another.

Initiate the Conversion

Once you’re ready to start, you must contact your plan administrator or related brokerage. They will guide you through the necessary paperwork and arrange the transfer of funds from your 401(k) to the Roth 401(k) offering.

Remember that you can convert the entire balance or only a portion of your retirement account if you elect a rollover.

Pay the Tax Bill

After you initiate the conversion, you’ll need to address the tax bill. You can choose to withhold taxes from the converted amount, but this could potentially trigger an early withdrawal penalty if you’re under 59 1/2.

A better strategy might be to use outside funds to cover the tax liability, thus keeping the entire balance of your retirement plan intact.

Monitor and Adjust Your Retirement Plan

Remember, converting your 401(k) to a Roth 401(k) is just an option in your retirement planning journey. It’s essential to continually monitor and adjust your retirement plan based on your evolving financial goals and circumstances.

Consider partnering with a financial advisor or tax advisor to make the most of your new Roth 401(k).

Benefits and Drawbacks of Converting a 401(k) to a Roth 401(k)

Converting a tax-deductible 401(k) to a Roth 401(k) offers several potential benefits and drawbacks. Understanding these can help you make an informed decision about whether a conversion is right for you.

Benefits of Converting

• Letting your funds build through tax-free growth.
• Tax-free withdrawals can be used as retirement income after age 59 1/2. This could significantly boost your retirement savings if you expect to be in a higher tax bracket in retirement.
• As of 2024, Roth 401(k)s won’t be subject to Required Minimum Distributions (RMDs), which means your money can continue to grow tax-free for as long as you want, unlike traditional 401(k)s, where you have to begin withdrawing funds at age 73. This may allow you to leave your savings to your beneficiaries as part of your broader estate planning.

Drawbacks of Converting

• The immediate tax liability is a key drawback of converting. This upfront cost may be hefty and could even push your ordinary income into a higher tax bracket for the year of the conversion.
• Additionally, once you convert to a Roth 401(k) and pay that tax money, you can’t undo the conversion as you could in the past.

Additional Factors to Consider

When deciding whether to convert a 401(k) to a Roth 401(k), consider your current tax bracket, expected future tax rates, time horizon until retirement, and estate planning circumstances.

Consulting with a financial advisor or tax professional can help you evaluate your unique situation.

Current and Future Tax Rates

When deciding whether to convert a 401(k) to a Roth 401(k), two important considerations are your current and expected future tax rate.

• If you are currently in a lower tax bracket and anticipate moving into a higher tax bracket in the future, it may be beneficial to convert to a Roth 401(k) now and pay taxes at your current rate.
• On the contrary, if you expect to be in a lower tax bracket in the future, it may be beneficial to defer the taxes now with a traditional 401(k) and pay them later upon withdrawal in retirement when your tax rate is lower.
• Remember, the converted funds will be considered taxable income in the year of conversion, so it’s essential to understand how they will affect your overall tax liability.

This aspect of decision-making involves a fair bit of speculation about future income levels, tax rates, and even potential changes in tax law. Therefore, consulting with a tax advisor or financial advisor can provide valuable insight and help you make an informed decision.

The Five-Year Rule

The five-year rule is critical when planning a 401(k) to Roth 401(k) conversion. According to the IRS, Roth 401(k) holders must wait at least five tax years before making qualified, penalty-free withdrawals of earnings, regardless of their age. This rule applies separately for each conversion, meaning the clock starts ticking on January 1st of the year you made the conversion.

If you fail to meet the five-year rule and withdraw the earnings portion of your Roth 401(k) early, you might be subjected to a 10% early withdrawal penalty on the earnings portion of your early distribution. As such, considering your timing and understanding the five-year rule is crucial in your conversion planning.

Time Horizon Until Retirement

Your time horizon until retirement can significantly impact the potential benefits of a 401(k) to Roth 401(k) conversion. The longer the time frame until you start making withdrawals, the longer your savings have to grow tax-free within the Roth 401(k).

If you anticipate that it will be many years before you need to access your retirement funds, a Roth 401(k) could provide substantial tax-free growth. This is particularly beneficial for younger investors who have a long time until retirement and can tolerate the short-term tax hit in exchange for long-term tax-free growth.

Estate Planning Considerations

Lastly, converting a 401(k) to a Roth 401(k) could have significant estate planning benefits. In terms of inheritance, Roth contributions.

• Unlike traditional 401(k) accounts, as of 2024, Roth 401(k) accounts aren’t subject to Required Minimum Distributions during the owner’s lifetime, allowing for potentially greater growth over time.
• However, inherited Roth 401(k)s are subject to RMDs by the beneficiaries, but these withdrawals are typically tax-free.

A Roth conversion could be a strategic move to reduce the size of your taxable estate and leave a tax-free inheritance to your heirs. However, estate planning can be complex, and the right approach depends on your specific circumstances, so it’s advisable to consult with a professional advisor or estate attorney.

Moving Forward With Your 401(k) Roth Conversion

You’ll need to consider many factors when deciding whether a Roth 401(k) conversion is right for you. Among them are your current and future tax rates, your ability to pay the tax bill resulting from the conversion, the time you plan to hold the account before making withdrawals, and your estate planning goals.

Understanding these complexities cannot be overstated, and professional advice can prove to be invaluable. Working with a financial advisor or tax professional can help you evaluate a conversion’s potential benefits and drawbacks based on your unique situation.

When it comes time to execute a rollover or to consolidate your various retirement accounts, Capitalize can be your trusted partner.

Learn how we can help you manage your rollover and consolidate your retirement savings today.