Brian Wynne, CPA

Tucked into the recent “Fiscal Cliff” bill (the American Taxpayer Relief Act of 2012) was a provision allowing an individual to convert amounts in their 401(k) plans to a Roth 401(k).   Previously, an individual could only convert amounts that were otherwise available to withdrawal from their 401(k), meaning after leaving their job, retiring, or reaching age 59 ½.  Under the new rules, as long as Roth contributions are offered by the employer’s 401(k) plan, employees can convert amounts while still employed, and at any age.  

Roth 401(k)s vs. Regular 401(k)s
There are several advantages to having funds in a Roth account as opposed to a more traditional tax-deferred 401(k):

• Earnings in the account are sheltered from tax as long as they are in the Roth account.
• Withdrawals from Roth accounts are not taxed (unlike 401(k)s and IRAs which grow tax-deferred but are taxed at withdrawal).
• Though Roth 401(k)s mandate that distributions start at age 70 ½, amounts can be rolled over into Roth IRAs, which have no such mandate.  Effectively, this allows Roth accounts to avoid the required-minimum-distribution rules.
• When Roth accounts pass down to your heirs at death, they continue to enjoy tax-sheltered earnings and tax-free withdrawals, though at that point required minimum distributions must begin.

Traditional 401(k) plans and traditional IRA plans are funded with pre-tax dollars, meaning the amounts contributed to the plans have not yet been taxed.  Earnings are sheltered from tax while inside the plans and then the distributions are fully taxable in retirement, achieving a powerful deferral in taxation.  Roth 401(k) plans and Roth IRAs are funded with post-tax dollars (money that has already been taxed).  Like traditional 401(k) and traditional IRA plans, earnings are sheltered from tax while inside the plans, but Roth distributions are fully tax-free when withdrawn.

If you anticipate taxes to be higher when you are drawing down the money in the future, Roth accounts make a lot of sense.  If you think your taxes will be lower in the future, a tax deduction now is worth more, so a regular 401(k) might make more sense.

The Catch
There is, they say, no such thing as a free lunch.  In order to convert from a 401(k) to a Roth 401(k), you must pay the piper:  just like a Roth IRA conversion, the entire amount converted becomes taxable income in the current year.  This provision is intended, after all, to be a revenue raiser for the government.  This means that you must have the funds available outside of your retirement account to pay the tax on the conversion.  However, there is not a requirement that this conversion is all or nothing – you could convert small amounts each year to help minimize the tax on the conversion.  With the other changes in the tax code affecting higher-income earners, it might be wise to keep your income levels from spiking in any one year.

Finally, there is one other disadvantage.  When you convert an IRA into a Roth IRA, you have the option to undo the conversion until a certain date if the value of the account declines in value (meaning you were taxed on more than what you ultimately ended up with).  There is no corollary with 401(k) conversions – once the money is converted there is no mechanism to undo the move.

Even in light of these disadvantages, this is a nice option to have available in your retirement planning, especially for younger employees.  If an employer doesn’t already offer Roth 401(k) accounts, but they begin to offer them in the future, you now have the option to move money over, and if the Roth approach is right for you, that tax-free growth can be a powerful retirement tool.