5 Times a Roth 401k Conversion is a Good Idea

5 Times a Roth 401k Conversion is a Good Idea

Roth IRAs have become one of the most popular ways to build retirement savings over the years.  In fact, they’re so popular that thousands of people clamor every tax season to convert their traditional IRAs to Roth IRAs.

This conversion is one of the most popular financial planning moves, since it can reduce your tax burden and eliminates required minimum distributions (RMDs).

More recently, a new form of Roth account has emerged: Roth 401k plans.  Roth 401k plans are essentially the same alternative to traditional 401k plans that Roth IRAs are to traditional IRAs.  Contributions are made after tax, and gains and withdrawals are tax free.

And with Roth 401k plans on the scene, many sponsors are starting to allow their participants to convert their traditional, pretax 401k balances into Roth, after tax balances.  This transition is known as a Roth 401k conversion.

Roth 401k conversions are not unlike Roth IRA conversions.  The transition will create taxable income, but your assets will never leave your employer’s 401k plan.

Here’s how one might work:

  • Johnny has a $100,000 saved up in his employer’s 401k plan.  He didn’t pay any income tax on his contributions, and they will continue to grow tax free until he starts taking withdrawals.
  • When he starts taking withdrawals after age 59 1/2, he’ll owe income tax on every dollar he takes out of his account.
  • If Johnny were to convert his 401k contribution to Roth contributions, he would owe income tax on the entire $100,000 this year.  His account would continue to grow tax free as it would have otherwise.
  • But, when he begins taking withdrawals down the road, they won’t be taxable income to Johnny.  Essentially, he would be paying his tax burden now instead of later.

Conversions can be appealing.  You pay taxes on the account now, rather than in the future when you might be in a higher bracket.  But the decision is not always so cut and dry.  And since this is a question I get in my practice from time to time, I thought it’d help to share 5 circumstances where a Roth 401k conversion is a good idea.

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