Should I roll over my 401(k) into a Roth 401(k)?
If your employer-sponsored qualified retirement plan has a designated Roth program, you may be able to roll over funds from your standard 401(k) to the plan’s Roth 401(k) option.
Just because the option exists doesn’t mean it’s the right move for everybody. The biggest consideration is comparing whether you benefit more from the tax-free contributions made today with the standard 401(k), or whether you will see a better return by paying the tax now and benefitting from tax-free withdrawals in retirement.
There are several other considerations for converting a standard 401(k) into a Roth 401(k), including:
Immediate tax consequences. When performing an in-plan rollover into a Roth, you will be rolling over an account consisting of pre-tax funds that have grown tax-deferred into an account that will grow tax-free and provide tax-free income. Therefore, the rollover will result in a taxable event.
The typical rollover will result in the entire amount, including earnings, being included in the participant’s gross income. That essentially means if you transfer a $10,000 balance from your standard 401(k) to a Roth 401(k), your reportable income for that tax year will increase $10,000, less any basis in the amount transferred.
The tax owed on the rollover will not be deducted during the rollover process. Instead, it is advised that you either increase your income tax withholding or make an estimated tax payment for the period in which the in-plan Roth rollover occurred. Otherwise, you will pay the tax on the rollover when you file your returns for the year. If the amount was large enough, you may owe an underpayment penalty when you file your returns.
You have to wait five years to withdraw without penalty. Because you’re doing a direct rollover, there is no tax penalty for making an early withdrawal from the retirement account. However, any distributions from the new Roth 401(k) account may be subject to early withdrawal penalties if withdrawn within five years of the rollover.
Your take-home pay or your plan contributions will decrease. Depending on how much you contribute to your 401(k), your take-home pay will decrease after you have conducted the in-plan rollover. That’s because you do not receive a tax deduction for contributions to a Roth 401(k).
For example, if you contribute $10,000 a year to a standard 401(k), your taxable income is reduced by $10,000. This is not the case with a Roth 401(k). You’re essentially paying less in taxes and keeping more of your paycheck by contributing to a regular 401(k) than you would be contributing to a Roth 401(k). The benefit of the Roth plan is being able to withdraw money from the account tax-free several years down the road.
If you need the same amount of take-home pay, then your other option is to decrease your contributions to your 401(k). If your employer matches your contributions, this could cause an even greater loss of retirement funds.
In-plan rollovers are irreversible. An in-plan rollover from a standard 401(k) to a Roth 401(k) cannot be reserved after the transfer is made and cannot be returned to the account from which the transfer was made.
This differs from the treatment of rollovers from a standard IRA to a Roth IRA. Those plans permit you to recharacterize IRA funds within a certain time limit. Recharacterization is an IRS term that simply means you can undo or reverse a rollover or conversation to a Roth IRA. You typically have until October of the year after doing the rollover to recharacterize your IRA funds.
This is not allowed with a 401(k). Once the transaction is made, you cannot undo it, and the funds must remain in the Roth 401(k).
Plan loans. If your plan allows, you should be able to roll over any outstanding loan balance from the non-Roth account to the Roth 401(k), provided there is no change in the loan’s repayment schedule. That means you do not have to pay the loan off or incur a tax penalty if you have an outstanding 401(k) loan at the time of the rollover.
Also, assuming the plan allows, you can borrow most any amount from your Roth account, including amounts that you rolled over from the previous 401(k) account.