Roth 401(k) Conversions Explained

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Earlier in 2013, with the passage of ATRA (American Taxpayer Relief Act) there was a provision to loosen the rules for 401(k) plan participants to convert monies in those “regular” 401(k) accounts to the Roth 401(k) component of the account.  Prior to this, there were restrictions on the source of the funds that could be converted, among other restrictions.  These looser restrictions apply to 401(k), 403(b) and 457 plans, as well as the federal government Thrift Savings Plan (TSP).

Recently, the IRS announced that guidance was available to utilize the new conversion options.  As long as the 401(k) plan is amended to allow the conversions, all vested sources of funds can be converted, even if the participant is not otherwise eligible to make a distribution from the account.

This means that employee salary deferrals, employer matching funds, and non-elective payins to the 401(k) account can be converted to a Roth 401(k) account (as long as the plan allows it).  Previously, only employee deferrals were eligible to be converted, and then only if the participant was otherwise eligible to make distributions from the 401(k) account, such as being over age 59½ (if the plan allows) or having left employment.

The converted funds will remain under the purview of the 401(k) plan’s distribution restrictions.  Administrators of 401(k) plans can choose to amend their plan to allow these new conversion options or limit existing conversions as they see fit.

Any conversions will cause the converted funds to be included in your ordinary income for the tax year of the conversion, most likely triggering income tax on the additional ordinary income.  If you don’t have funds outside the 401(k) plan to pay the tax on the conversion, the whole operation becomes less attractive, since you’re having to take a (presumably) unqualified distribution of funds to pay the tax on the conversion.  In the future, qualified distributions from the Roth 401(k) account will be treated as tax-free (as with all Roth-type distributions).

For example, if you have a 401(k) account with $100,000 in it and you wish to convert the entire account to your company’s Roth 401(k) option.  If your marginal tax bracket for this additional income is 25%, this means that you would have a potential tax burden of $25,000 on this conversion.  If you have other sources to pull this $25k from, then you can convert the entire $100,000 over to your Roth 401(k) plan.

However (say it with me: “there’s always a however in life”), if you don’t have an extra $25,000 laying around to pay the taxes, you might need to withdraw the money from your 401(k) plan to pay the tax – which would also trigger the 10% penalty on the withdrawal plus tax which adds up to an additional $8,750.  So now your conversion has cost nearly 34% overall – and the chance of such a conversion paying off due to higher taxes later becomes less likely.

And then there’s the additional rub: most 401(k) plans have significant restrictions on taking an in-plan distribution such as the one mentioned above to pay the tax.  Your plan may allow the Roth 401(k) conversion distribution, but not the regular distribution while you’re participating in the plan, so you’re stuck – and will be stuck with a huge tax bill the following April.