Making Roth Conversions Part of Your Retirement Strategy

Diversifying your tax burden is an important part of planning for retirement.  Taxes can drain retirement savings quickly, especially if the entire amount is subject to tax.  It’s important to diversify tax exposure to have both tax-deferred and tax-free sources of income during retirement.  With tax-free withdrawals, Roth conversions can be an effective part of a retirement strategy. 

What is a Roth 401k?

A Roth 401k is funded by after-tax contributions which can later be withdrawn tax-free.  While traditional 401ks give a tax break at the time of contribution, the Roth 401k gives its tax break at the time of distribution. 

The recent passage of the American Taxpayer Relief Act (ATRA) now allows employers to offer the option of in-plan Roth conversions.  Participants can convert some or all of their pre-tax contributions to a Roth, if plan sponsors give this option.  Previously, only the amounts that were already distributable were eligible for Roth conversion. 

Is a Roth conversion worth it?

So is converting to Roth worth it?  It will cost an upfront tax break, so it is important to weigh the factors.

- Time

The more time the Roth account has to grow, the better the tax benefit.  Paying tax on contributions is like paying tax on the seed, rather than on the resulting harvest.  In order to realize the tax benefits, the account must be allowed to grow for an extended period of time. 

In general, Roth conversions may be a more powerful strategy for young workers who can allow the account to grow for 10 or more years.  A long period of growth gives greater potential for tax savings.

- Income tax bracket

• Many work and retire within the same bracket.  Converting to a Roth incurs a tax during the year of conversion.  This may put the participant in a higher tax bracket than at the time of distribution, minimizing the tax benefit of the Roth conversion. In this case, converting to Roth may not be worth it. 

• Roth conversions can provide a source of tax free income in retirement.  They also help diversify a participant’s tax burden.  Consider if Roth conversions may be a powerful addition to your retirement strategy.