Should You Convert Your Traditional 401(k) to a Roth 401(k)?

Some taxpayers swear by the mantra of not giving the Internal Revenue Service any money until it's absolutely necessary. So why have some investors been converting their retirement dollars from traditional to Roth, paying taxes on their money now rather than when they withdraw it during retirement?

It all started back in 2010, when investors of all income levels were allowed to convert their IRA assets from traditional to Roth. Prior to that time, only those with incomes of less than $100,000 could execute conversions. Congress threw in an additional sweetener to get the money flowing in the door, enabling those who converted their IRAs in 2010 to split the taxable income due on the converted amounts over two tax years, 2011 and 2012. As a result, some financial-services providers reported a surge of conversions in 2010's waning days, and investor interest in conversions has stayed high even though that tax-splitting provision has expired. The reason? With currently low tax rates set to expire at the end of 2012, many investors think it's a good bet that tax rates will never be so low again. 

Amid the hubbub over converting IRA balances, one maneuver that has been less frequently discussed is the ability of some investors to convert traditional 401(k) balances--taxed upon withdrawal--to Roth 401(k)s. That provision was part of the Small Business Jobs and Credit Act of 2010. Participants in 403(b) and 457 plans are also now eligible to convert their assets from traditional to Roth status.

Yet in contrast with IRA conversions, which are now available for all investors, converting assets in a company retirement plan to Roth status is only an option for a subset of retirement-plan investors. Depending on their status, they might only be able to convert a portion of their balances, and even if an employee is able to convert from a traditional to a Roth retirement plan, doing so might not always be the best route to take.

Are You Eligible?
First, let's tackle the eligibility questions. If you want to convert to a Roth 401(k), your employer's plan must offer that option; the plan must also allow for in-plan conversions from traditional to Roth. To be clear, it's not mandatory for all plans to offer the Roth 401(k) option or in-plan conversions; rather, employees can only take advantage of conversions if their plans offer these features.

Even if your plan meets those criteria, there are still some wrinkles to bear in mind that narrow the availability of in-plan conversions. For starters, only a limited subset of individuals--those who have left or retired from their former employers, are age 59 1/2, or are disabled or dead--can convert their 401(k) balances from traditional to Roth.

If you don't meet those criteria, you can only convert the portion of your balance that consists of employer-matching or profit-sharing contributions, again, assuming your company's plan provides the option to do so. And even then you must meet one of the following criteria: You must be age 59 1/2, the contributions you'd like to convert must have been in the plan for at least two years, or you must have participated in the plan for at least five years. (This IRS Q&A delves into conversion eligibility in even greater detail.)

And Is It a Good Move?
Once you've gotten your arms around whether you're eligible to convert your 401(k), 403(b), or 457 assets to Roth--and the preceding illustrates that that's far from everyone--the next step is to assess whether that's a good move. For most individuals, I'd argue that the opportunity is not as exciting as it first appears.

That's because, as IRA expert Ed Slott argues in this video, people who are eligible to do an in-plan conversion from a traditional 401(k) to a Roth--for example, those who are age 59 1/2 or have left their employers--already have a way of obtaining Roth status on those assets: They can roll their traditional 401(k) assets directly into a Roth IRA.

That's usually preferable to moving the money into a Roth 401(k) for a few key reasons. First, they can invest in nearly anything they like within the IRA framework, and they can also circumvent the additional layers of fees that dog some 401(k) plan participants. Investors in Roth IRAs also have the advantage of not being required to take distributions after age 70 1/2, though that benefit is somewhat illusory in that Roth 401(k) holders can readily roll their assets into a Roth IRA at a later date, thereby circumventing the need to take required minimum distributions.

Perhaps even more important, those who convert from a traditional to a Roth 401(k) are giving up an important escape hatch of which IRA holders can avail themselves: the ability to "do over" the conversion if it appears to have not been a great idea. For example, let's say I had $50,000 sitting in my IRA that I decided to convert to a Roth, thereby triggering a tax bill on the amount of my IRA that consisted of assets on which I'd not yet paid tax. But if my foreign-stock-heavy portfolio subsequently slumped in 2011, I'd be able to "undo" my conversion, go back to my traditional IRA, and convert back to a Roth at a later date, provided I minded the p's and q's outlined in this article. In so doing, I'd be able to reduce my conversion-related taxes. By contrast, those who convert assets within a 401(k) plan cannot recharacterize: Once they've converted, their stuck with their decision, regardless of whether it turned out to be advantageous or not. 

That said, conversions within the confines of a 401(k) plan might make sense if you need extra creditor protections or there's a risk you may be sued. If that's the case, it's worth noting that company retirement-plan assets might enjoy greater legal protections than IRAs in some states.

Beyond those distinctions, the basic analysis that goes into determining whether you should convert from a traditional 401(k) to a Roth 401(k) is the same as it is for IRA assets. As with the IRA decision, a conversion isn't advisable for 401(k) assets if you don't have external assets--that is, separate from what's in your 401(k)--to pay the taxes due upon conversion. You'll also want to carefully think through whether your tax rate today is apt to be higher or lower than it is in the future, as my colleague Adam Zoll discussed in this article, as well as what effect a conversion will have on your marginal tax rate in the year in which you execute the conversion.

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