It often makes sense for the owner of a regular 401(k) retirement plan to convert the entire plan to a Roth plan. That will mean that the money converted to the Roth plan will be subject to regular federal income taxation at the time of the conversion. But the withdrawals will be free of federal income tax for life.
In contrast, the contributions to the regular 401(k) plan are tax-deferred — the contributions are not taxed, but the participant pays the federal income tax when the regular distributions are withdrawn during retirement.
Converting non-Roth money from an existing plan to a Roth plan is called an in-plan Roth rollover (IRR).
The Roth conversion is more involved when factors such as the balance in the account as well as the age and tax situation of the participant are taken into consideration.
Let’s look at the pros and cons of this move.
When undertaking the Roth conversion, the participant must pay federal income tax on the amount being converted. The taxes cannot be paid with money that is in the account. The amount being converted during a calendar year must be reported to the IRS as gross income.
The good news, however, is that the amount being converted is not subject to the 10-percent penalty that is imposed on withdrawals from a regular Roth 401 k plan before retirement. Nor is the amount subject to a compulsory 20-percent tax withholding.
Participants should therefore try to determine whether the taxes they will have to pay on conversion from the regular 401(k) plan now will be greater than the taxes they will have to pay on their present plan when they withdraw funds in retirement.
Effect of age
Should the participant be young and in a lower tax bracket, the conversion might be a good idea. The taxes they will pay when converting to a Roth 401 k will be less, the money they invest will have the chance to grow tax-free, and they will not have to pay taxes when they draw on it later.
Another benefit is that contributions can be made to the Roth 401 k plan even after 70½ should the participant continue to earn an income. Under the regular plan, such contributions cannot be made.
Consider the heirs
Conversion to a Roth plan could be a good idea for high net-worth individuals who foresee never withdrawing all the money from their plan, no matter how long they live. The lump sum that is left will be a non-taxable inheritance to their heirs.
Weighing the tax consequences
Generally, for those who are close to retirement and in a higher tax bracket the conversion achieves little of value. Their tax liabilities are likely to be lower in retirement, although it does depend on other sources of income, such as social security and income from other retirement plans.
In most cases, documentation should be altered to permit in-plan Roth conversions. It should contain provisions for in-service distribution. Vested amounts are the only ones that can be converted.
It is important, too, to keep detailed records for 1099-R requirements.