If you are not familiar with the new provisions, here’s a rundown. Workers of any age can now convert all or part of their traditional 401(k) balance to a Roth 401(k). Like any Roth conversion, they’ll pay tax on the amount converted, but once converted, Roth balances will grow forever free of tax.
How is this new? Previously, the conversion option was only open to those retiring or separating from service.
Potential problems with 401(k) conversions
Just like a standard Roth conversion, the new 401(k) option can be a powerful tool in the tax and retirement strategy toolbox. However, it isn’t going to be useful for most people, and here’s why:
1. To take advantage of this provision, your employer has to offer both a traditional 401(k) and a Roth 401(k). In truth, most employers do not. According to Carolyn T. Geer, business writer with The Wall Street Journal, “fewer than half of employers offering regular 401(k)s also offer the Roth version.” That may change over time, but for now, most 401(k) participants without a Roth option are out of luck.
2. As with all Roth conversions, when you convert dollars from your traditional 401(k) to a Roth 401(k), you have to pay tax on the full amount of the conversion right away. That poses two problems. It really only makes sense if you have the dollars available outside your 401(k) to pay the tax. Most people don’t.
3. Here’s the third stumbling block. Again, as with all Roth conversions, the conversion is most appealing if you believe that at retirement, you’ll be in a higher tax bracket than you are now. While overall taxes may indeed be steeper in future years, you may not be in a higher bracket.
For example, many people (excepting those with healthy pensions and very sizable retirement accounts), will be in a lower bracket after retirement, since their taxable work income will stop. For people like that, it may not make sense to use precious resources to pre-pay tax now, especially if it’s possible their tax bill may be lower down the road.
But sometimes it makes sense
Writes Ashlea Ebeling of Forbes, “a Roth conversion makes sense if you expect your tax rate to be the same or higher in retirement and won’t need the funds for a decade or more.” And therein lies the opportunity. We’ve helped clients execute some very successful and timely “no brainer” conversions in years when, for a variety of different reasons, their income dipped to negligible levels. A conversion makes imminent good sense in a year when you’re paying minimal tax. In that case, it’s very likely your taxes will be higher in future years, and you’re wise to sneak a conversion in under the wire.
A conversion may also be a good move if your assets are over-concentrated in tax-deferred retirement accounts, with little or no assets available to you without tax or penalty. (Do you know how many times have we’ve seen people with hundreds of thousands of dollars in retirement accounts but no money to pay their car repair bill?)
We would rather see clients diversify assets across a variety of account types (e.g. IRA, Roth, non-retirement accounts) to help them fine tune their tax and income flows both before and during retirement. If they’re short on assets outside of their work retirement plan, a 401(k) conversion may help rebalance the boat.
But for most people, especially in families with two incomes, it’s hard to believe that tax rates are lower now than they will be when everyone stops working. And without that confidence, it may be best to hold off on any conversion. As Ebeling points out, 401(k) to Roth conversions lack the “ability to undo the conversion in the following calendar year if you change your mind,” or if the market tanks. Translation: once you give your money to the IRS, you’re not going to get it back or be given a do-over. For that reason, if you are set on converting, a smaller or partial conversion may be better than a huge, whopping one-time bet.
The bottom line
While the new 401(k) conversion alternative could be a great option for a select few, that doesn’t necessarily mean you. Take a long, hard look at the facts before you fall for all the buzz. In the world of financial planning, just because you can do something doesn’t mean you should.