Is a Roth 401k Conversion the Right Decision For You?

Uncle Sam Roth 401k ConversionBack in January of 2013, we were relieved to have averted the so-called fiscal cliff that had been the non-stop talk of the 24-hour news cycle throughout the end of 2012.

While many aspects of the compromise—known as the American Taxpayer Relief Act of 2012 (ATRA)—were both well-reported and somewhat controversial, one benefit of the Act may have escaped your notice: the ability to convert assets in tax-deferred accounts, such as 401k and 403b retirement accounts, into a Roth 401k account.

You may remember that a Roth retirement account (broadly speaking) differs from a traditional IRA and other tax-deferred accounts, like a 401k specifically in when you pay taxes. A traditional IRA and a 401k will allow you to contribute pre-tax dollars into the account, which will then grow tax-deferred. When you withdraw funds from those tax-deferred accounts, you will then owe money to Uncle Sam based on your income tax and on capital gains tax.

Your Roth account, on the other hand, is funded through after-tax dollars. That means you cannot deduct your contribution from your taxes, making your tax burden higher in the year that you make the contribution. But once you have paid those taxes, your Roth account is then tax-free. When you make withdrawals (provided you have the Roth 401k for at least five years and wait until the minimum age of 59½), every single penny is yours to keep.

When you pay your taxes can make an enormous difference in your bottom line now and in the future. With the new provisions set out by ATRA, it might be tempting to convert your 401k account into a Roth 401k account and spare yourself taxes in retirement. Here’s what you need to know about converting to a Roth 401k and mitigating your tax burden now and in the future.

Why Do a Roth 401k Conversion?

While death and taxes may be life’s only certainties, we are lucky enough to live in a country where we have a little control over when we pay some taxes. Roth 401k retirement accounts, since they can be withdrawn tax-free, can be a very attractive option for young investors. That’s because withdrawals from tax-deferred accounts (like 401ks and traditional IRAs) are taxed at ordinary income tax rates.

Workers in their 20s, 30s, and even 40s can generally plan on having a rising income for the next thirty years—with a rising tax rate. Which means they will pay higher income taxes on their withdrawals than they would have paid on the income they earned in the year that they contributed it.

By paying income taxes up front before funding a Roth 401k retirement account, these young investors are potentially paying a much lower tax burden now compared to the income tax rate they will face during their highest-earning years—which tend to be right before retirement.

The Catch-22 of this situation, of course, is that young investors are less likely to be able to afford to fund a Roth 401k account. Losing the tax deduction can make it much more difficult to fully fund a Roth 401k account, particularly when you are in the midst of major life events like getting married, having children, furthering your education, etc.

Converting a 401k account into a Roth 401k compounds these issues further. If you decide to convert a pre-tax deferred account into a Roth, then the total amount of your rollover is fully taxable in the year of that conversion. For those who have healthy 401k balances, that could result in a nasty tax bill in the here and now.

If you do decide to convert to a Roth 401k account, you will have to make sure you have the cash on-hand to pay the tax due in the year of conversion. Otherwise, you might have to dip into the retirement account itself in order to pay your tax bill, which will result in an early-withdrawal penalty of 10% of the amount withdrawn.

One way of maximizing the benefits of conversion without unduly hurting your current taxes is to only convert a portion of the money in your 401k into a Roth 401k. This will provide you with some tax-free income in retirement, without overburdening your current ability to pay taxes.

Tax and retirement experts (and PT) state that diversifying your tax burden in this way is just as savvy as diversifying your assets in your retirement accounts.

Who Can Do a Roth 401k Conversion?

Unfortunately, the Roth 401k conversion option is not available to all workers. Your employer will have to decide to offer this option, even though all plan sponsors (that is, employers), now have the right to amend their plans to include such Roth 401k conversions.

According to Kimberly Lankford of Kiplinger,

“…only about 34% of the 401k plans administered by Fidelity offer Roth 401k [accounts], for example, and only 12% of those plans have been amended to permit these in-plan conversions.”

For right now, these conversions are not as widely available as they should be. However, it’s a good idea to talk to both your plan administrator and your HR department to find out if and when your employer will make the amendment to their plan. The more people who ask about this, the more likely employers it is that will be encouraged to make the conversion available to their employees.

Mitigating Your Tax Burden When You Convert

One way of lowering your tax bill in the year of your conversion is through strategic charitable giving. Giving a sizable financial gift to charity will offset your increased tax burden, which can help to make the conversion more affordable.

As Fidelity Charitable points out, this strategy…

“may be most appropriate for someone who already donates regularly to charity and has sufficient non-retirement assets to do both: pay the cost of the conversion and make a (likely) larger-than usual charitable donation in the year of the conversion.”

If you do not regularly make large donations to charity, this strategy will simply be exchanging one large cash outlay for another—and depending on your tax liability, it may not completely offset your increase in taxes.

However, having the option of choosing where your hard-earned money goes is not only very fulfilling, particularly in a year when you have a higher-than-average tax bill, but it also gives you the satisfaction of doing good with your money.

The Bottom Line

Converting your 401k into a Roth 401k can be a great decision that your future self will thank you for. But the immediate costs can put this kind of conversion out of reach for some investors.

If you are unable to make such a conversion—either because it’s not available at your place of work or because you simply cannot afford the tax implications—consider opening a Roth IRA as an additional retirement account. It will help to diversify your tax liability, and give you more places to stash money for retirement. That’s a win-win.

Have you ever made a Roth 401k conversion? What’s your experience in doing it? Are you considering the move? Does your employer allow it yet?

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About Emily Guy Birken

Emily Guy Birken is an award-winning writer, author, money coach, and retirement expert. Her four books include The Five Years Before You Retire, Choose Your Retirement, Making Social Security Work For You, and End Financial Stress Now. Learn more about Emily at


    Speak Your Mind


  1. DenverEric says

    I agree on your thoughts about converting to a Roth, but for the record the fiscal cliff did happen. It just wasn’t that big of a deal.

  2. CommonCentsWealth says

    I have not made a conversion before, but my employer just recently began offering a Roth 401k option.  It seems like a decent option, but there is no guarantee that your tax rate will be higher in retirement (which means a Roth is a good idea), so I think I’ll diversify myself between roth and traditional accounts.