Roth Rules: When to convert your 401(k) to a Roth IRA.

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I recently received an email from a client who left his job.  He had quite a bit of money in his 401(k) and wondered if rolling it over to a Roth IRA was the right decision.  That’s a question we get a lot, actually.  The rule that only individuals who make less than $100,000 annually can convert a 401(k) to a Roth IRA is long gone (2010), so everyone leaving a company now is faced with the decision.  And answering it isn’t an easy ‘yes’ or ‘no’.  Here’s how to determine if it’s right for you.

Defining the two

Both 401(k)s and Roth IRAs are retirement savings accounts.  In both cases, you make contributions to the accounts while you are still working, and those funds are invested in a diverse portfolio of stocks, bonds, mutual funds, and CDs.  The biggest difference between a 401(k) and a Roth IRA is when the money is taxed.  With a 401(k), contributions are made from your paycheck before taxes are deducted. Come retirement, when you withdraw the money, you pay income tax on that money.  Roth IRAs work the other way.  Roth IRAs provide no tax breaks for contributions (you pay taxes before you invest), but earnings and withdrawals are generally tax-free.  That’s why some people refer to Roth IRAs as growing “tax-free”.

Is it right for you?

Whether you convert an existing a 401(k) to a Roth IRA depends on your current income tax rate and the tax rate you expect to pay when you retire.  If you expect to be in a higher tax bracket at retirement (and don’t automatically discount that possibility; see below), then converting to a Roth may be the right choice.  If not, then explore other options.

Landing in a higher tax bracket after retirement isn’t as far-fetched as it sounds.  Yes, your salary (income) might be higher now, but you also have the benefit of several large deductions that you likely won’t later — your children, your mortgage, and your 401(k) contributions.  Those all lower your taxable income.  At retirement, your overall income might drop, but your taxable income might increase due to those now-missing deductions.  That just might push you into a higher tax bracket, and having tax-free Roth distributions at that point could be more advantageous.  

Additional pros and cons

There are other advantages to a Roth IRA conversion.  With a 401(k), you are required to start withdrawing from the account at age 70 ½ .  There is no such requirement with a Roth. So, if you think you might want to do something else with the money besides use it yourself (pass it to heirs, for example), then a Roth conversion is the right choice, as heirs can also withdraw that money tax-free.  Still, the biggest reason to convert is to avoid paying a huge lump sum in taxes at retirement (if your tax bracket is going to be higher).

Do understand, however, that converting to a Roth IRA now will send the IRS straight to your wallet.  The IRS charges income tax on all tax-deductible contributions, so moving your current 401(k) to a Roth IRA now means that the entire current balance will be taxed at your current income tax rate. A person in the 28% tax bracket with a 401(k) balance of $100,000, for example, would need come up with $28,000 to cover their tax bill.  The IRS gives you two years to pay that bill, but it still might be too burdensome to make the switch.  Roth IRAs are also not protected from creditors or attorneys, so if you’re going to continue working in a field that is subject to malpractice or other lawsuits (medicine, for example), then a Roth IRA may not be your best bet.

Bottom line?

Talk to your tax professional.  There are several options for your 401(k) available after you leave a company. The wrong move could cost you tens of thousands in taxes and penalties, while the right one could feather your retirement nest for years to come.  Let us help you devise a strategy that sets you on the right course.

 

What questions do you have about your retirement accounts?  Please comment below!

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