Roth 401(k) conversion fiscal cliff silver lining
Amid tax hikes and continued uncertainty, some may find one financial golden nugget in the fiscal cliff mess. A new rule will allow many more U.S. workers to convert their 401(k) retirement account into a Roth 401(k).
401(k) vs. Roth 401(k)
A Roth 401(k) differs from a traditional 401(k) in that contributions to the account are taxed when they are made, and can be withdrawn later tax free. Conversely, contributions are not taxed in a traditional 401(k). Instead, the money withdrawn later after retirement is subject to taxation.
In the past, Roth 401(k) accounts have only been available to taxpayers with so-called “distributable” funds, most of whom are 59.5 years old or older.
Under the new rule — a short-term revenue-generating move which kicks in on March 1 — a Roth 401(k) will be an option for nearly anyone with a 401(k) and an employer with a benefits package that offers conversions to Roth 401(k).
Those who benefit from conversion
Why is conversion a benefit? It isn’t always, but if you are moving up the ladder so to speak and have reason to believe you will retire in a higher tax bracket than you are in now, its may be a good idea to switch to a Roth 401(k) account. Then you pay the current tax rate on contributions now. It is certain a higher rate will be in effect later, after retirement. Then, when you do take withdrawals from the account later, it is all tax free.
Jack Otter explained it in his book “Worth It … Not Worth It?,” quoted by Business Insider:
“By making the maximum contribution to a Roth you are saving more money for retirement than if you max out a traditional IRA. Why? Because you are paying the tax now, and you’ll get to keep 100 cents of every dollar in that account. With a traditional IRA, you’ll have to give 10 or 20 or 25 cents of every dollar to Uncle Sam as you make withdrawals.”
Those who don’t benefit from conversion
Those who expect to retire in a lower tax bracket (perhaps you plan on becoming a monk) should pass on conversion to a Roth 401(k). Likewise, somebody who has contributed significantly to his or her traditional 401(k) may balk at the tax hit in one fell swoop at conversion.