Is a rollover to Roth 401k a good idea? As you’ll see in a minute, you may have this option at your current employer. If you leave your job, you won’t be able to do this but you can roll your old 401k to an IRA. Ok. Let’s get back to the issue at hand but first let’s take a look at what a Roth 401k is.
Basically, it is similar to a Roth IRA in that you get no deduction for your contributions, but the growth and eventual withdrawals can be tax-free. As a result, you get tax-free retirement income. Another huge plus is that you might make your Roth IRA beneficiary very happy.
The government recently enacted laws to make these plans available. 40% of existing plans out there carry a provision to allow this change, so your employer might offer this to you soon. The question is, should you go for it? And if you own your shop, is this the best 401k for small business owners?
Generally speaking, the older you are, the less attractive the 401k Roth plan is. That’s because the real benefit of tax-free growth requires…well…eh…growth. The longer you keep your money in the plan, the longer the growth has an opportunity to….eh…grow.
You need that growth to make up for the big tax hit you take when you first roll over your money to the Roth 401k. That’s right. If you “take advantage” of the Roth 401k, you’ll have to pay income tax on all the money you take out of your 401k and roll into your Roth 401k.
Can you guess why the government is so anxious to make these plans available? That’s right…the boys and girls in D.C. want to get their hands on those tax dollars. But I digress. Let’s get back to you.
Another reason you might want to pass on this plan is if you will be in a lower tax bracket by the time you start making withdrawals. If that describes you, you’re probably better off to take the tax deduction now while you’re in a high bracket and take (taxable) withdrawals when you retire in a lower bracket. In short, stick to your old 401k.
And as you might have guessed, that’s the scenario most of us considered when we first started contributing to the retirement plans anyway. Put the money in while we work and are in a higher tax bracket. Take the money out when we retire and are in a lower bracket. Simple.
So who is the Roth 401k a good fit for?
The younger you are, the better it is. Also, the higher the tax bracket you’ll be in when you retire, the more attractive the plan is.
But there are a few other considerations — not the least of which is that if you put your money into the Roth 401k, it’s easier to spend. That’s because when you make qualified withdrawals, they won’t trigger income taxes. Believe it or not, that’s my biggest beef with this plan.
My experience tells me that people tend to accumulate assets when it’s difficult or painful to access that money. Most people I meet have most of their money in retirement accounts for exactly those reasons. The Roth 401k doesn’t have those obstacles, and that worries me.
You might tap that cookie jar sooner rather than later if you have a Roth 401k. If so, that will be the greatest cost of using the Roth 401k.
What say you? Do you have the discipline to take advantage of the Roth 401k and not tap it? Would you roll your 401k over the Roth 401k?
bob says
February 20, 2011 at 2:04 PMI disagree with your statements.
“The longer you keep your money in the plan, the longer the growth has an opportunity to….eh……grow.
You need that growth to make up for the big tax hit you take when you first rollover your money to the Roth 401k.”
The length you keep your money in the plan has nothing to do with it. Sure you get a tax hit when you rollover, but if you don’t you also get a tax hit when you withdraw from a traditional 401k. It just matters which tax hit is a bigger percentage.
Richard Hurt says
September 23, 2010 at 6:22 PMGreat post! I was in that situation and had to choose whether to move my Traditional IRA to a Roth and chose not to for the very reason you cite on tax consequences. I think your insight on ease of access to the funds under the Roth is also very enlightening.
JoeTaxpayer says
September 23, 2010 at 4:26 PMMy beef about Roth Mania is that many will do a wholesale conversion, paying more tax now, and in retirement not having enough income to fill the lower brackets.
My beef is that there’s more to the decision than the two endpoints. You are at 25% now, 33% in retirement? Ok, but in the 25 years in between good luck having no year of un- or under- employment. /Those are the year to convert at least partially.
Abigail says
September 22, 2010 at 8:43 AMWell, when I started my Roth, I was on disability and my husband was on unemployment. As a result, we made about $30,000 a year. So it made good sense to contribute to a Roth.
Now that I found a job I can actually work (whoohoo!) I’m earning $30,000 a year on my own and the boss implied that yearly raises are pretty standard. In addition, however briefly, I have some contract work. So we’re making about $50,000 a year. My husband is going on disability but still hopes to find a job he can do soon. So that raises us — again, however briefly — to at least $60,000 a year.
In other words, it probably makes sense to start a regular IRA for him. Then, if our income fluctuates, we’ll have the option of allocating as best suits our interests.
Oh and one thing you didn’t point out: While the government obviously wants some tax dollars, it’s a great time for people who are on unemployment to roll over to a Roth. They’ll pay low, low taxes this year on their earnings up to now.
neal says
September 24, 2010 at 4:51 PMExcellent point. You (and Joe below) point out — income fluctuation is the standard and not the norm now. Use that to your advantage by being dynamic with your decisions about Roth/IRA/Contributions/Distributions