offer valuable tax deferral, Roth 401(k)s can be tax-free. With
the latter, all distributions avoid income tax five years after
your first contribution, if you're at least 59-1/2.
The new tax law makes it easier to switch to a Roth 401(k),
effective Jan. 1, 2013.
Now, anyone can convert 401(k) funds to a Roth version, at any
time. Before, you had to be eligible for a distribution, usually
by reaching a certain age or leaving the company.
Here's the catch: You have to pay tax on the amount converted,
using your current income tax rate.
The new rules also apply to the Roth versions of 403(b),
457(b), and thrift savings plans. If your employer's plan has a
Roth option and if it allows such conversions, you can make the
Suppose Art Smith, age 35, has worked at his company for 10
years, building up a $200,000 401(k) balance. Last year, his
company added a Roth option. Art can transfer his $200,000 to the
Roth version, pay tax upfront, and let the account balance build
up for eventual tax-free withdrawals.
If Smith is in the 28% tax bracket this year, a full
conversion would cost him more than 28% (or $56,000). He could
pay more than $60,000 because adding $200,000 to his income
pushes him into the 33% bracket for the year.
Smith's $200,000 in the Roth account, assuming a 5.7% average
annual return, might grow to $800,000 when he retires at 60. He
can take out all that money tax-free.
If Smith keeps the money in the traditional tax-deferred
401(k) and he's still in the 28% bracket at retirement, he'd pay
28% on withdrawals.
Paying tax now at 28% and 33% in order to avoid 28% tax later
doesn't make sense. So when will an in-plan Roth conversion
"A conversion can pay off if you believe that you will be in a
higher-tax bracket when you take withdrawals," said Richard
O'Donnell, tax analyst at Thomson Reuters. That might be the case
if your income will be higher then.
Or you might believe that tax rates will be higher in the
future. Paying tax now at 28% and even 33% might avoid future
withdrawals at, say, 38% or 48%.
No one knows what future tax rates will be. So the normal rule
of delaying taxes as long as possible might apply, especially if
you don't have $60,000 lying around.
Still, it might be prudent to move part of your traditional
401(k) to a Roth account each year, over a period of years,
O'Donnell says. Withdrawals from a Roth can be tax-free in the
future, even if tax rates soar.
One tactic is to fill up your current tax bracket. Suppose
Smith is single, with expected taxable income of $100,000 in
The 28% bracket this year goes up to $183,250 for single
filers. So Smith might convert up to $83,250 of his traditional
401(k) to a Roth 401(k) in 2013. He'll have to cough up $23,310
Smith will stay in the 28% bracket that way. On a $40,000
conversion, for example, he'll owe an extra $11,200 in tax: 28%
times $40,000. If he earns 10% a year on that $40,000, then when
he's 60, he'll be able to take $433,338 from his account tax
Smith can do this for several years, with a relatively modest
cost. Eventually, he can bring his traditional and Roth 401(k)
balances into the mix he wants, between current tax deferral and
future tax-free withdrawals.
Spreading a Roth conversion over several years makes it easier
to pay the tax from nonretirement funds. Tapping an IRA or a
company-sponsored plan for money to pay the tax generally robs a
Roth conversion of its value.