Pros and cons of converting to a Roth 401(k)

CHICAGO Thu Jan 24, 2013 9:55am EST

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CHICAGO (Reuters) - It was a small but important line item in the recent "fiscal cliff" deal. As part of the American Taxpayer Relief Act of 2012, Congress made it possible for all retirement savers to convert their 401(k) accounts to a Roth 401(k) without moving money out of the workplace plan.

The law permits all retirement savers to convert existing 401(k) retirement plan assets to a Roth 401(k), so long as their plan offers Roth options and adds the conversion feature. Previously, conversions could be done only by savers who also were eligible to take a distribution from the plan -- in most cases, people age 59½ or older.

What do Roth conversions have to do with the fiscal cliff? Very little.

In theory, conversions will generate income tax revenue, and Congress needed to find some to get the fiscal cliff deal done. The Roth 401(k) expansion is projected to generate $12.2 billion over 10 years, because income tax is due in the year of conversion from a qualified account. But the Roth provision really is an accounting gimmick, since it merely accelerates payment of taxes the government would otherwise get down the road when account holders take distributions in retirement.

And the benefit to retirement savers? That's more complicated.

The option to use Roths inside workplace plans has been gaining ground, mostly because Roth accounts offer powerful long-term tax benefits -- for some savers. But even if your employer decides to offer the new Roth conversion option, it will come with some drawbacks that should give you pause.

Consider that:

-- Your tax burden could shift.

The relative advantages and disadvantages depend on your tax situation and outlook. Roths are less advantageous for those who expect to be in a lower tax bracket in retirement. However, a conversion, with a plan for continued Roth contributions, would be a good fit for younger workers in lower tax brackets who want to protect themselves against possible future higher marginal tax rates, or for wealthy folks who don't expect to be in lower brackets in retirement.

--There is no going back.

Roth IRAs feature a nifty "take-back" feature that allows you to undo conversions that don't work out. If you convert IRA assets that subsequently fall in value, you still owe taxes on the amount of the original conversion. "Re-characterization" allows you to reverse the conversion and send the assets back to your traditional IRA.

But the Roth 401(k) conversion does not include a re-characterization feature. "It's an important benefit you get in converting to a Roth IRA," says Kaye Thomas, a tax attorney and author of several books on taxes and investing. "You get the hindsight benefit not just on your planning but on the investment decision."

That means the Roth IRA conversion will be a more attractive option for most people. "Think of it as a hierarchy of conversions," says Kevin O'Fee, vice president of defined-contribution product management at Fidelity Investments. "If you have a choice, the re-characterization feature puts the IRA conversion ahead of the Roth 401(k)."

-- Required distributions still apply.

Roth IRAs have no required minimum distributions (RMDs) after age 70½ -- a terrific feature that can help you control your tax burden in retirement and even pass along assets to your heirs tax-free (though heirs would have to deal with RMD requirements). Roth 401(k) accounts, however, are subject to the standard RMD requirements, although you can address this problem by rolling over your account to a Roth IRA when you hit age 70.

WHY IT MIGHT WORK

Roth 401(k) conversions have been allowed since September 2010, and about half of employers offer the option. So far, the conversion rate has been slow. Fidelity Investments reports that 37 percent of workplace plans it administers had added Roth options by the end of 2012, which represents 57 percent of all participants. But just 6 percent of savers who have the option have chosen to use Roths.

O'Fee says employees have enough trouble getting the right investment allocations and contribution rates in their 401(k)s, let alone figuring out whether Roths are a good move.

"It's adding another feature that's different from what we've taught people to do over the years -- which is to defer, defer, and defer," he says.

The good news is that Roth accounts can be more valuable than 401(k)s over the long haul because you contribute post-tax dollars, which then grow tax-free forever - assuming you don't make withdrawals before age 59½. By contrast, withdrawals from 401(k)s or traditional IRAs are taxed as ordinary income.

Participants can contribute much more to a workplace Roth because the limit is governed by the same rules covering pre-tax 401(k) contributions -- $17,500 this year. With a Roth or traditional IRA, you can contribute only $5,500 annually. (Joint filers can contribute the full amount if their adjusted gross income is $178,000 or less; for single filers, the limit is $112,000.)

Roths also offer a great way to add flexibility to your retirement income draw-down strategy. "Many people will be working longer, and accessing Social Security," says O'Fee. "That all generates taxable income, so having a sleeve of Roth income gives you maneuverability."

O'Fee says he doubts there will be a rush to convert to Roth 401(k)s. But he thinks the option can help bring about a longer-term realignment of the way people plan for retirement. "Any time we can get people to think about diversifying, that's a positive."

(The writer is a Reuters columnist. The opinions expressed are his own. For more from Mark Miller, see link.reuters.com/qyk97s)

(Follow us @ReutersMoney or here. Editing by Beth Pinsker and Douglas Royalty)

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