4 Quick Steps To Convert Your Traditional 401(k) To A Roth 401(k)

converting 401k to roth

Let’s face it. Doctors and other high-income professionals pay a lot of taxes. They’re unavoidable. But when it comes to your retirement savings, you have a choice as to when you want to pay them. Now, or later? One potential way to save on taxes later is converting a 401(k) to a Roth 401(k). 

Before we get into how or should you convert these accounts, let’s break down each type of account.

Roth IRA

One of the most popular ways to save for retirement is the Roth IRA. Why? Because they grow tax-free and their withdrawals are also tax-free  Unfortunately, most high-income earners can’t directly contribute to them.

Income limits

As of 2019, the income contribution limits are:

Single filers – Phase-out starts at $122,000; ineligible at $137,000

Married filers – Phase-out starts at $193,000; ineligible at $203,000

Contribution limits

The IRS recently raised the total amount you can contribute to either a Roth IRA or a Traditional IRA from $5,500 to $6,000. People 50 and over can now contribute an additional $1,000 for a total of $7,000.

Backdoor Roth IRA

One of the ways that high-income earners can invest in Roth IRAs is through something called a Backdoor Roth IRA.

A Backdoor Roth is simply a conversion of money in a traditional IRA to a Roth IRA. Currently, anyone can convert money that they have put into a Traditional IRA to a Roth IRA, no matter how much income they earn.

All of this works because, in 2010, the federal government removed the income limits for IRA conversions, creating a Roth IRA loophole.

Of course, you’ll need to get the mechanics right. Consult your accountant and/or tax attorney if you have any questions before doing so.

If you’re interested in learning step-by-step on how to convert your Traditional IRA to a Roth IRA, read:

4 Simple Backdoor Roth IRA Steps Every High Income Earner Needs To Know

What Is a Roth 401(k)?

The Roth 401(k) was originally introduced in 2006 and set up to combine features from both the:

  • Traditional 401(k)
  • Roth IRA

Like a traditional 401(k), you can take advantage of the company match on your contributions.

You pay taxes on Roth 401(k) contributions before they get deposited into your account. Once you meet certain qualifications, your contributions plus any earnings can be withdrawn tax-free.

Similarities Between a Traditional 401(k) and a Roth 401(k)

Company Match – Both a traditional 401(k) and a Roth 401(k) have the ability to include a company match. If your employer offers one and you choose not to contribute, it’s the same thing as you giving up free money. If you’re trying to decide where to start investing, always start with an employer-sponsored plan that has a match.

Same Contribution Limit. For 2019, the contribution limit is $19,000 per year or $24,500 if you’re over 50. High-income professionals have the ability to put away much more money than they could with traditional or Roth IRA ($6,000/yr).

Differences Between a Traditional 401(k) and a Roth 401(k)

The main difference between the two plans is how the contributions you put in each year are taxed.

Pre-tax – Like a traditional IRA, when you contribute to a traditional 401(k), you’re using pretax dollars. That means the money goes into your 401(k) before you pay taxes on it. The upside is this makes your taxable income lower. The downside is that in retirement, the withdrawals you make are taxed.

Post-tax – On the other hand, contributions to a Roth 401(k) use post-tax dollars. That means you invest the money after you pay taxes on it.

Which leads us to the biggest benefit of the Roth 401(k): Because you already paid taxes on your contributions, the withdrawals you make in retirement are tax-free.

As a side note, you should know that if you receive an employer match, that portion will still be taxable in retirement but your contributions aren’t.

Example:

Dr. A reaches retirement and is now in the 25% tax bracket. He has tried to live like The Millionaire Next Door, and has done a great job of amassing $1 million in his traditional 401(k). Once he starts withdrawing money, $250,000 (or 25%) is going to the tax man. Ouch!

If instead, he’d read this article 🙂 and invested in a Roth 401(k), that entire $1 million is all his.

Is a Roth 401(k) right for you?

Before converting a traditional 401(k) to a Roth 401(k), seek advice from your tax professional and/or financial adviser. Everyone’s situation is different.

The main reason for advice is that making the switch is going to initiate a tax bill. Why? The money in the traditional 401(k) was put in before taxes were paid on it. Once the conversion is completed, that money is taxed.

Sound confusing?

Here’s an example:

Dr. Roth has $100,000 in a traditional 401(k) and is contemplating a Roth conversion. He’s currently in the 30% bracket, which will require him to pay $30,000 in taxes. He wants to take $30,000 out of the account to pay his tax bill but is advised NOT to. By reducing his account by the $30,000, he’ll miss out on years of compound interest.

Instead, he was informed to save up before converting and have the cash on hand to cover the tax bill.

Here’s something else to consider. If you don’t like the idea of having to pay the taxes from the conversion then simply leave your traditional 401(k) alone and begin funding a new Roth 401(k) instead.

How to Convert Your Traditional 401(k) Into a Roth 401(k)

1) Check to see if it’s possible.

There are some companies that don’t allow the conversion. Make sure to check with your employer to see if this is an even an option.

2) Check your employer’s vesting schedule.

A vesting schedule is an incentive program set up by an employer which, when it is fully “vested,” gives the employee full ownership of certain assets — usually retirement funds or stock options. It is an employer’s way of giving employees a reason to stay with the company. To be 100 percent vested means that you are able to take all of your retirement benefits with you if you leave or have been fired.

All of the money you contribute is immediately vested, but your employer’s contributions are usually vested over time. Check with your employer first, before proceeding.

3) Calculate how much you owe in taxes.

As we discussed earlier, when making a conversion, you will owe income tax on the amount you are converting from a Traditional 401(k) to a Roth 401(k).

I recommend you speak with your tax adviser first, but you can get a guesstimate by simply multiplying the amount you plan on converting by your income tax rate. Remember to set that amount aside or save up until you have enough to pay the taxes without tapping into your 401(k).

4) Finalize the conversion process.

Once you have funds lined up to pay for the conversion, it’s now time to make it happen. Your employer can provide the specific details on how to convert your account as well as providing you the specific forms needed.

My Recommendation

If available, I recommend that you invest in the Roth 401(k). Why? Because you’re contributing after-tax income, then you get the benefit of tax-free earnings.

Not only do your earnings grow tax-free, but once you reach the age of 59.5, you pay no taxes when you start taking money out.

Predicting the future

No one can know how the tax brackets will change in the future, especially if you’re still decades away from retirement. I’m counting on my tax bracket to be lower during retirement, but only time will tell.

For me, I’d rather pay taxes now while I’m still working instead of later when I’m not.

Summary Comparison

I found this chart below that will help you decide on which account is right for you.

Roth Comparison Chart via IRS.gov:

Roth 401(k), Roth IRA, and Pre-tax 401(k) Retirement Accounts

 Designated Roth 401(k) 

 Roth IRA

Pre-Tax 401(k) 

 Contributions

Designated Roth employee elective contributions are made with after-tax dollars.Roth IRA contributions are made with after-tax dollars.Traditional, pre-tax employee elective contributions are made with before-tax dollars.

 Income Limits

No income limitation to participate.Income limits:

  • 2019 – modified AGI married $203,000/single $137,000
No income limitation to participate.

 Maximum Elective Contribution

Aggregate* employee elective contributions limited to $19,000 in 2019Contribution limited to $6,000 plus an additional $1,000 for employees age 50 or over in 2019Same aggregate* limit as Designated Roth 401(k) Account

 Taxation of Withdrawals

Withdrawals of contributions and earnings are not taxed provided it’s a qualified distribution – the account is held for at least 5 years and made:

  • On account of disability,
  • On or after death, or
  • On or after attainment of age 59½.
Same as Designated Roth 401(k) Account and can have a qualified distribution for a first time home purchase.Withdrawals of contributions and earnings are subject to Federal and most State income taxes.

 Required Distributions

Distributions must begin no later than age 70½, unless still working and not a 5% owner.No requirement to start taking distributions while owner is alive.Same as Designated Roth 401(k) Account.
* This limitation is by individual, rather than by plan. You can split your annual elective deferrals between designated Roth contributions and traditional pre-tax contributions, but your combined contributions  cannot exceed the deferral limit – $19,000 in 2019  ($25,000 in 2019 if you’re eligible for catch-up contributions).

 

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