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If you’ve been diligently saving for retirement through your employer’s 401(k) plan, you may be able to convert those savings into a Roth 401(k). The Roth 401(k) may offer you some added tax advantages. Here’s what you should know if you’re considering this conversion.
Key Takeaways
- Traditional 401(k)s and Roth 401(k)s are taxed differently.
- Traditional 401(k)s use pre-tax contributions and the money grows tax-deferred—that is, you’ll need to pay taxes on it during retirement.
- Roth 401(k)s use after-tax dollars and grow tax-exempt—that is, qualified withdrawals are tax-free during retirement.
- “Qualified” means you’ve waited at least five years since your first contribution to your Roth 401(k) to withdraw funds.
- If you convert to a Roth 401(k), you’ll owe taxes on the money now. These taxes will depend on your tax bracket.
How to Convert to a Roth 401(k)
Here’s a general overview of the process of converting your traditional 401(k) to a Roth 401(k).
- Check with your employer or plan administrator to see if converting is an option.
- Calculate the tax of converting.
- Set aside enough money from outside your retirement account to cover what you’ll owe when you file your taxes.
- Tell your employer or plan administrator that you’re ready to make the conversion.
- The process from here may differ from company to company, but the plan administrator should be able to provide you with the necessary forms.
Not every company allows employees to convert an existing 401(k) balance to a Roth 401(k). If you can’t convert, consider making your future 401(k) contributions to a Roth account rather than a traditional one. You are allowed to have both types.
As mentioned, you’ll owe income tax on the amount you convert. After you calculate the tax cost of converting, figure out how you can set aside enough cash—from outside your retirement account—to cover it. Remember that you have until the date you file your taxes to pay the bill. For example, if you convert in January, you’ll have until April of the following year to save up the money.
Tip
Don’t rob your retirement account to pay the tax bill for converting. Try to save up for it or find the cash elsewhere.
Should You Convert to a Roth 401(k)?
If your company allows conversions to a Roth 401(k), you’ll want to consider two factors before making a decision.
- Do you think you’ll be in a higher tax bracket during retirement than you are now? If so, that can be a good reason to switch to a Roth. You’ll pay taxes now at a lower tax rate and enjoy tax-free income later when your tax rate is higher.
- Do you have the cash to pay taxes on the conversion? You’ll owe income tax on any money you convert. For example, if you move $100,000 into a Roth 401(k) and you’re in the 22% tax bracket, you’ll owe $22,000 in taxes. Make sure you have the cash to cover the tax bill—and don’t use money from your 401(k) to pay it. Otherwise, you’ll miss out on years of compounding growth. And that could end up costing you a lot more than $22,000.
Is the Contribution Limit the Same for Traditional 401(k)s and Roth 401(k)s?
Yes, traditional 401(k)s and Roth 401(k)s have the same contribution limit.
What’s the Difference Between a Roth 401(k) and a Roth IRA?
Though the Roth 401(k) and the Roth individual retirement account (IRA) share the same tax treatment—no upfront benefit, but tax-free qualified withdrawals in retirement—there are differences.
For starters, the contribution limits are different. Also, with a Roth IRA, you can’t contribute if your income is above a certain threshold. With a Roth 401(k), there are no income limits. So if your income is too high for a Roth IRA, you may be able to have the 401(k) version.
In addition, there are no employer-matching contributions with a Roth IRA. With a Roth 401(k), many employers will match some or all of the money you contribute.
What Do Most Employers Contribute to a 401(k)?
Of the employers that contribute to employee plans, most typically contribute amounts that match a certain percentage of workers’ salaries.
The Bottom Line
Employer-sponsored 401(k) plans are a convenient tool for building a secure retirement. Many employers now offer two types of 401(k)s: the traditional, tax-deferred version and the Roth 401(k).
The biggest difference between a traditional 401(k) and a Roth 401(k) is when you get a tax break. With a traditional 401(k), your taxable income is reduced by the amount of your contributions, lowering your tax bill the year you contribute. With a Roth 401(k), you don’t get an upfront tax break, but qualified withdrawals will be tax-free. (“Qualified” means that it’s been at least five years since you first contributed to the account.) That is, once you put money into a Roth, in most cases, you’re done paying taxes on it.
