Roth 401(k) In-Plan Conversions

Photo courtesy of José Martín Ramírez Carrasco on unsplash.com.

As of the beginning of 2013, a new provision became available for participants in 401(k), 403(b) and 457 deferred compensation retirement plans: the Roth 401(k) In-Plan Conversion.  This provision allows current employees participating in one of these Qualified Retirement Plans to convert funds from the traditional 401(k) (or other) account into the Designated Roth Account (DRAC) that is part of the plan.

This is new and different because previously the only way to convert funds from the 401(k) plan to a Roth-like account was to have left employment by the sponsoring employer.

Employers must amend their 401(k) plan documentation in order to provide for this provision – it’s not a requirement, in other words.  If your employer has amended the plan documents to allow for in-plan conversions, you may convert any or all vested funds from the traditional 401(k) plan into your Roth 401(k) plan.

This conversion is considered to be a withdrawal from the 401(k) plan, so ordinary income tax will be due for the amounts converted – and you generally do not have access to plan funds to pay this tax.  This means that you must have other funds available to take care of paying the tax when you enact an in-plan conversion.

The amount of the withdrawal will be reported and included in your taxable income, added to your wages and other income for the year.  Since our ordinary income tax rates are progressive, adding more income quite often results in increasing the tax rate applied to the converted funds.

For example, if you are single and your “regular” taxable income is $75,000, your marginal tax rate, meaning the rate at which your last dollar of income is taxed at, is 25%.  Your average tax rate on this $75,000 of income is 19.47%.  If you enacted an in-plan conversion of $25,000 from your 401(k) to your Roth 401(k), your taxable income is now $100,000.  The marginal tax rate on this level of income is 28%, and the average tax rate is 21.18%.  The resulting increase in tax, in real dollars, is $6,569.50, for a real tax cost on the conversion of 26.28%.

As we’ve discussed in previous articles, it generally only makes sense to convert money to Roth treatment if you believe that your future tax rates will be greater than your current tax rates.  It is for this reason that the Roth In-Plan Conversion is not a very attractive option.

Keep in mind as well that Roth 401(k) funds are subject to required minimum distributions (RMDs) once the participant who has left employment reaches age 70½, just like traditional 401(k) funds, but unlike the Roth IRA.  This can be side-stepped by rolling over the funds from your Roth 401(k) account to a Roth IRA after you’ve left the employer.

Situations Where a Roth In-Plan Conversion May Make Sense

Low income. If you have a relatively low income and have been participating in the 401(k) plan, it could make good sense to convert some or all of your vested 401(k) plan balance to Roth.  This could come about if you have variable income (such as farm income or sales, for example) and you have a year where your expected taxable income will be lower by average than other years.  Again, you must have outside (non-401(k) account) funds available for paying the additional tax.

Estate Planning. If you don’t expect to use the 401(k) funds for your own purposes in retirement and you’d like to pass along the money to your spouse or heirs, conversion to Roth will eliminate the tax burden for your beneficiaries.

Higher tax rate expected.  If you’ve read the tea leaves and believe that your future tax rates will be higher than at present, converting funds to the Roth could be a way to reduce your overall tax cost.