In an effort to unlock tax revenue, not just raise rates on the wealthy, architects of the fiscal cliff deal handed certain retirement savers a small bonus: You can now convert traditional 401(k) plan assets into a Roth 401(k) regardless of age and employment status.
Under the old rules, to convert you typically had to leave your job, retire, become disabled, or reach age 59½ and be eligible for normal distributions. So this is welcome flexibility, though it won’t be available to everybody. Only 40% of employers offer a Roth 401(k) in the first place, and not all of those plans allow conversions. But at those that do, there is now nothing to stop you from making the switch.
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Whether you should is another matter. Roth 401(k) contributions are made after tax; they grow tax-free. Traditional 401(k) contributions are made pre-tax; they are taxed upon withdrawal. In general, you need to believe you’ll be in a higher tax bracket in retirement for the conversion to make sense. You also need enough other funds to pay the potentially sizable one-time tax bill that comes due when you convert.
This switch works a lot like a conversion outside your 401(k)—from a traditional IRA to a Roth IRA. And the thinking for doing so is much the same. Likely candidates are young workers in a low tax bracket who can benefit from decades of tax-free growth. Another likely candidate is anyone who has suffered a temporary income lull, and can take a large distribution without being shoved into a higher tax bracket. A conversion might also make sense if you convert smaller amounts each year in order to afford the tax and not be pushed into a higher bracket.
One important difference with this conversion is that it cannot be reversed. Outside your 401(k) plan, assets converted to a Roth account can be “recharacterized” later in the year and shifted back to a traditional IRA if you change your mind. This is a valuable feature because if you convert, say, $1 million and your portfolio suddenly slumps to $500,000 you would still owe tax on the $1 million—unless you recharacterize. But you cannot do that with a 401(k) Roth conversion. There, all sales are final.
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Financial planners doubt there will be a rush to convert traditional 401(k) assets to Roth 401(k) assets. Still, lawmakers expect enough interest in the conversion to unlock $12.2 billion in tax revenue over the next decade. That near-term revenue is what drove the change, handing savers an extra layer of flexibility.