As part of the fiscal cliff deal reached a few weeks ago, Congress expanded the availability of in-service conversions of traditional 401(k) accounts to a Roth 401(k). This also applies to other retirement savings plans including the 403(b); 457(b); and the government’s Thrift Savings Plan.
A couple of requirements:
- Your organization’s plan has to offer a Roth option.
- Your plan needs to allow for these in-service provisions.
The thought process is that many savers will flock to this new opportunity which would generate a lot of new near-term tax revenue for the government. So far, according to media reports, savers have not taken advantage of this new wrinkle to any great extent.
Is an in-service Roth conversion a good idea for you? Here are a few things to consider before converting some or all of your retirement plan account:
Do you have the money outside of the plan to pay the income taxes associated with this move? If the answer is no, stop here the rest of this is pretty meaningless to you.
Think through the costs versus the anticipated benefits. You lose out on any future earnings from the cash used to pay the current income taxes. Compare the amount of the current taxes that you will need to pay against the amount of future taxes that you anticipate saving. Determine the number of years until you realize those tax savings, select a discount rate, and then calculate the present value of those tax savings. The discount rate should equal a percentage rate of return that you would expect to earn on the cash used to pay the taxes. Compare the present value to the amount of taxes that will be due on this conversion.
Some might say the cash is earning nothing in money market account. That may be true, but in reality you might invest that money elsewhere, and at some point interest rates are likely to rise, increasing returns money market accounts and CDs.
In general the ability to convert is more beneficial to younger savers who have a long time until retirement. They will generally be in a lower current tax bracket and they have a longer time to recoup the amount paid in current taxes.
Roth 401(k)s are relatively new and only about half of the retirement plans out there offer them. Utilization by participants is under 20 percent. If a Roth is right for you, the Roth 401(k) offers some attractive benefits over a Roth IRA:
- The contribution limits are higher than for a Roth IRA. In 2013 you can contribute $17,500 ($23,000 if 50 or over) via salary deferral to a 401(k) plan. The limit for an IRA (Roth or otherwise) is $5,500 ($6,500 for those 50 and over).
- There are income limits on Roth IRA contributions, there are no such limits on your ability to make a Roth 401(k) contribution.
Is the Roth 401(k) conversion opportunity right for you? Think through all of the variables and do the math. This is not a “no-brainer” decision.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides financial planning and investment advice to individual clients, 401(k) plan sponsors and participants, foundations, and endowments. Roger is active on both Twitter (@rwohlner) and LinkedIn. Check out Roger's popular blog The Chicago Financial Planner where he writes about issues concerning financial planning, investments, and retirement plans.