401(k) In-Plan Roth Conversion Guide
If you do this, you will be required to pay ordinary income tax (taxed at your top marginal tax rate) on the conversion balance.
You can pay this amount using a portion of the money in your plan, or you can pay it out of pocket and keep your plan balance unchanged. (Most financial planners strongly recommend the latter option if you can afford it.)
The advent of Roth 401(k)s has had a noticeable impact on the savings habits of many employees who have access to these plans.
The idea of exchanging tax-deferred money for tax-free money is very appealing to a large segment of workers, especially those who project that their post-retirement income will be at least as high as it is now.
Updates to the tax laws in 2013 followed by revised IRS guidelines have made these plans more widely available, and have also opened the door for in-plan Roth conversions.
Who Can Benefit?
High income earners can use a Roth 401(k) as a tax shelter, and often this is the only way that they can contribute to any type of Roth account, as their income may be too high to allow them to make Roth IRA contributions.
But young low income workers in a low tax bracket can also do this while their tax bill is more reasonable and thus start building a pool of tax-free income to enjoy after they stop working.
A Roth account of any kind is great for use in estate planning, as it allows the donor to bequeath tax-free money to his or her beneficiary.
Roth Conversion Rules
Designated Roth accounts can’t be set up solely to accept in-plan rollovers – they must also accept elective deferrals from participants.”
This means that there can be no separation of Roth plans into conversion balances and elective deferrals.
These monies must be combined inside a 401(k) or other type of qualified plan.
The IRS web page addressing this issue went on to list out the types of contributions that could be converted to Roth contributions, including:
- Elective salary deferrals
- Matching contributions
- Nonelective contributions
- After-tax employee contributions
- Amounts rolled into the plan from another plan
- Qualified matching contributions (QMACs)
- Qualified nonelective contributions (QNECs)
The IRS allows each plan administrator to determine which (if not all) of these contributions are convertible.
The administrator can also mandate when or how many times per year a Roth conversion can be made.
There are also three different parties that may elect to do an in-plan Roth rollover:
- The employee
- A surviving spouse beneficiary
- An alternate payee who is either a spouse or ex-spouse
The 10% early withdrawal penalty is not assessed on a Roth rollover, but tax and penalty may apply if the plan participant takes a distribution from the Roth account before he or she has had a Roth plan or account open for at least five years.
Finally, Roth conversions are irreversible and plan sponsors are prohibited from withholding income tax on the conversion balance.
401(k) In-Plan Roth Conversion FAQs
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.