Should You Convert Your 401(k) Into a Roth 401(k)?

Pros of a Roth 401(k) Conversion

A Roth 401(k) is similar to a Roth IRA. Unlike a traditional 401(k) that's funded with pretax dollars, a Roth 401(k) is funded with after-tax dollars. While you won't get a tax deduction upfront for a Roth contribution, you will enjoy tax benefits down the road:

• Your money grows tax-free. As long as you follow the rules on qualified withdrawals, you never pay taxes on your returns in a Roth 401(k)—not as your money grows and not in retirement.
• Your qualified withdrawals are tax-free. You pay ordinary income tax on traditional 401(k) withdrawals but you don't pay any income tax on qualified withdrawals from a Roth 401(k).

When you do an in-plan Roth conversion, you must pay income tax on the money you move. Note that you aren't avoiding taxes by moving your funds to a Roth 401(k): You're paying taxes on the money now instead of paying taxes on it when you retire.

Example: How a Roth Conversion Might Work

Say you have $2,500 in your 401(k). You're in the 22% tax bracket, so converting to a Roth will cost you roughly $550 in taxes. Meanwhile, you aren't planning to retire for another 30 years. If your $2,500 grows at 5% for 30 years, it could be worth $11,203 when you retire (use a calculator to work your own numbers). At 22%, your tax bill would eventually be $2,465 if you withdrew your money from a traditional 401(k) in retirement (assuming you didn't add any more to the $2,500). By paying $550 in taxes now, you avoid $2,465 in taxes later.

If you think your tax bracket might be more like 32% when you retire, your savings would be even higher: $550 compared to $3,585. Scale this example up or down to estimate the potential savings you might see, given your own account value and timeframe.

Cons of a Roth 401(k) Conversion

The same example may feel different when the conversion amount is $25,000, generating a tax bill of $5,500. And in fact, adding $25,000 to your ordinary income could put you into a higher tax bracket, causing your tax bill to edge up even more. If you converted $250,000, your tax bill might surpass $40,000.

Your upfront tax bill is the primary drawback to converting your 401(k) to a Roth 401(k), and it can be a big one. Other potential pitfalls that may make an in-plan conversion less desirable:

• Your money may not have time to grow. If you're planning to retire in a few years, for example, your account value may be similar to (or even less than) what it is today, reducing your potential tax savings.
• Your tax savings may not amount to much. Many people retire into a lower tax bracket. If this happens to you, you might be better off keeping your money in a traditional 401(k) and paying taxes when you withdraw it.
• A Roth 401(k) might not have the features you want. Although a Roth 401(k) is similar to a Roth IRA, there are a few key differences. You may not be able to make a tax-free early withdrawal from your Roth 401(k) plan as you would from a Roth IRA, if your employer's plan doesn't permit early distributions from your 401(k). Also, you must take required minimum distributions from your Roth 401(k); not so with a Roth IRA.

Should You Convert a 401(k) to a Roth 401(k)?

If you can, consult a financial planner or tax expert before completing a Roth 401(k) conversion. They can help you accurately assess the tax consequences and map out the potential tax benefits, both of which are highly individual. How do you know when to consider a conversion? Here are a few cases when it might make sense to look closer:

• You can shoulder the tax bill. If your upfront tax bill will send you into debt or require you to withdraw your retirement funds early to pay for it, your money might be better off where it is. Making an early withdrawal from an IRA will result in a 10% early withdrawal penalty and additional taxes. Making early withdrawals from your employer's 401(k) plan may not be possible, depending on their rules.
• You expect to be in a higher tax bracket later. Maybe you expect to build wealth over the years and enjoy a sizable income late in life. Or maybe your income is unusually low this year because you took time off to tend to your health, for example. In either scenario, a lower tax bracket could be an opportunity to convert funds at a lower tax rate.
• You have losses to offset income. If your non-retirement investments have taken a hit in the market this year, you may be able to use up to $3,000 in losses to offset the additional income from a Roth conversion.
• You want to avoid Roth contribution limits. Contributions to Roth IRAs are limited to $6,000 in 2022 and $6,500 in 2023 with a $1,000 catch-up contribution for people who are 50 and older. There are additional income limits for Roth contributions that may make it difficult for you to contribute to a Roth. Converting funds from a traditional 401(k) to a Roth 401(k) bypasses these limits.
• You have after-tax contributions to convert. Most contributions to traditional 401(k) plans are made with pretax dollars, which are taxable when you convert funds to a Roth 401(k). But if you've made any contributions to your 401(k) with after-tax dollars, you may be able to move them to a Roth 401(k) without incurring taxes. Be aware: Earnings on your contributions may still be taxable.
• You can live with the five-year rule. To avoid a special recapture tax equal to 10% of your early withdrawal, your converted funds must stay in your Roth 401(k) for at least five years beginning Jan. 1 of the year you do the conversion and ending Dec. 31 five years later. If you want to access your money in less than five years, a conversion may not work for you.

How to Convert Your 401(k) to a Roth 401(k)

Follow these three steps to complete an in-plan conversion:

1. Estimate your tax bill. Consult your tax pro or use tax software to calculate your additional tax bill.
2. Work with your retirement plan administrator to complete your conversion.
3. Adjust your withholding or make an estimated tax payment to avoid underpayment penalties at tax time. No taxes will be withheld when you make the conversion.

The Bottom Line

Converting your traditional 401(k) to a Roth 401(k) may offer long-term tax benefits, but check the math before you make a move. Your financial advisor, tax consultant or plan administrator may be able to help you make the right decisions about whether to convert your money and how much to convert if you do.