Just because you can convert 401k funds into a Roth 401k doesn’t mean you should. How do you know if it’s a good decision or not? Let’s take a look.
It’s well known that businesses large and small can offer up 401k plans. With such plans employees can deposit money into the account and it grows tax-deferred while it’s there. The employee also deducts that amount from her taxable income during the year she made the deposit. She will pay taxes at the prevailing income tax rate only when she starts tapping into the account. It’s a wonderful world.
A Roth 401(k) doesn’t give you any deduction for the year you make your deposit. But it grows tax free. And if you keep your money in the 401k Roth for at least 5 years and wait until you reach age 59 ½ to make withdrawals, those withdrawals are also tax free.
The Big News
There used to be all kinds of pesky restrictions on who could and who couldn’t take advantage of converting into 401k Roth plans. No more. New laws took effect at the beginning of the 2013 which allow anyone to convert from a 401k to a Roth 401k as long as their employer offers the option. These new improved rules also apply to 403b and 457b plans. Of course if you convert your 401k into a Roth, you’ll have to pay taxes (not penalties) on the transaction. Ouch. That burns.
For further discussion of the differences between the 401k and Roth see this post.
So the question remains, is it worth it to convert or not?
Let’s take a look at some numbers to identify the variables. Once you understand these, you can apply the concepts to your own situation. For our purposes let’s assume the following:
- You have $100,000 in your 401k now.
- You will remain in the 30% Federal and State income tax bracket while you are working and after you retire.
- You have $30,000 in an investment account. If you convert from a 401k to a Roth 401k you will use those funds to pay the tax.
- You can earn 7% (on average) on your investments inside and outside of your retirement account.
- You contribute $7000 per year to your retirement account and that’s all you can afford.
- You will retire in 30 years.
- You will use the income from all your investments for 25 years after you retire.
Let’s first consider the situation if you do absolutely nothing and allow the money to grow in your regular 401k. You have your $100,000 but that’s not all. Remember that you add $7000 a year to your retirement account and it grows at 7% too. The combined total accumulated value is $985,000 by the time you are ready to turn your time card in for a gold watch.
On top of that you still have that nice little investment account stash of $30,000. It grew at 7% gross but you had to pay taxes on the account at 28% so it grew at a net rate of 4.9%. 25 years from now that account will be worth a little over $99,000 if all goes as planned.
All combined, you’ll have a bit over $1,080,000. If we take a conservative retirement withdrawal rate of 4% out, that means you’ll be able to withdraw $43,200, pay 28% on that withdrawal and spend about $30,000 every year.
Now let’s consider the Roth 401k alternative. In this scenario you take your $100,000 and roll it over to the 401k Roth. When you do that you’ll owe $30,000 in taxes. That being the case, kiss your investment account goodbye. Of course you’ll still have $7,000 to make your contributions. But because those contributions aren’t tax deductible, your net contribution will be $5040. At the end of 25 years, your account total is $861,000. You can then withdraw your 4% and that works out to be about $34,500. But since its tax free, if you compare this to the option above, you’ll have an extra $4500 a year to travel with or buy stuff you don’t need.
The most important thing to understand when you are considering converting your 401k to a Roth 401k is that account balances are not important. It’s all about retirement income my friend….income.
The longer you have before you plan to tap into the account and the larger the account it, the better the conversion is. Also, the more growth oriented your investments are, the more sense the conversion might make. But remember that you have to make some assumptions about the future in order to make a decision and your assumptions could easily be off.
Still, it makes sense to go through this exercise, especially if you are a youngish person with many working years ahead. Have you converted your 401k to a Roth 401k? Why or why not? What other considerations are there?