In-Plan Roth 401(k) Conversion- Is It Right For You?

A Roth IRA is a wonderful vehicle, especially if someone has already maxed out their other tax-advantaged accounts (e.g., 401K).  For those not eligible for a Roth IRA or those who just can’t get enough Roth, there is a relatively new option – an in-plan conversion from a traditional pre-tax 401K to a Roth 401K.  Because of 2013 legislation, more participants than ever are now eligible for this conversion (as long as their employers’ plans allow it).

 The decision to convert from a standard 401K to a Roth 401K is similar to determining whether to convert from a traditional IRA to a Roth IRA. While there are numerous considerations, the primary advantage is that once it becomes a Roth, no additional taxes will be due.  The downside is that taxes must be paid now at one’s ordinary income tax rate (and in most cases, the taxes should be paid from non-retirement accounts).  The benefit of converting is due to the concept of “tax diversification” – owning some assets that are taxed now (e.g., Roth) and some assets that will be taxed in retirement (e.g., traditional IRA/401K).

For someone earlier in his/her career who might be at a lower 10%-15% income tax rate, a conversion could be a good strategy since rates are likely to be higher (or at least the same) in retirement.  But for someone who is a high earner, the additional income from the conversion could trigger a higher marginal tax rate as well as a phaseout of deductions and exemptions.  For these individuals, converting a large lump sum might not be optimal.

Due to the complexities, two sensible strategies could be to a) Contribute a portion of your 401K to a Roth.  For example, if you contribute $10,000/year, consider $5,000 for the traditional 401K and $5,000 for the Roth 401K; or b) Instead of a full conversion, convert smaller amounts each year to minimize the tax ramifications in any single year.

As we’ve said before on this blog, it’s very hard to estimate tax rates 10 years from now, let alone 20 or 30+ years away.  Before converting a large amount, talk to your accountant and financial advisor so they can help customize a solution for you.  

What Stories Can You Believe?

Does it ever pay to try to pick stocks that will outperform?  Maybe, but lots of research shows that the small group of stock pickers that exhibit positive results are more likely due to luck than skill.  It doesn’t stop us from trying though…many of us are lured by the siren song of having information that will allow us to outperform the market.  I just read an article by an investment firm that claimed that there were opportunities for selecting stocks in emerging markets because of the ability to exploit inefficient markets:

Good news: alpha potential remains high. The flow of information about countries and companies is slower and less transparent in developing markets, creating mispricings that resourceful stock pickers can exploit. 

If that were true, you would expect to see a good number of professional managers who invest in emerging markets outperform their benchmark.  If you really can develop an edge, the numbers should back up your claim.  Unfortunately, the data does not support this view.  Standard and Poor’s twice a year research report (SPIVA) found that 80% of all emerging market mutual funds failed to outperform their benchmark during the five year period through 12/31/2013.

Stories can sound compelling.  It is important to focus on the evidence when making investment decisions, especially when the person telling you the story has something to gain from you believing it!

More Evidence Of Behavior Impacting Performance

How do you or your advisor select which funds to purchase in your portfolio?  Seems like a simple question, but unfortunately, there isn’t a simple answer to it.  The overwhelming variable used to decide which funds to include in a portfolio is past performance.  Seems to make sense…you never hear someone say, “I have this great investment idea…mutual fund X has been in the bottom 5% of it’s peer group the last 5 years in a row and the manager has made some terrible bets that haven’t panned out.  I think it’s a screaming buy right now!”.   In fact, the reasoning behind investment decisions are usually just the opposite.  After some period of time of underperformance, investors grow tired and decide to invest in another fund that has what is perceived to be a better future and more competent management.

Vanguard has completed an interesting study that seeks to emulate this typical investor behavior.  They compared a buy and hold strategy against an investor with the following habits:

  • Start of analysis investor buys every fund in existence that has been around for at least 3 years and is in the top half of returns for their peer group
  • Every calendar year the investor sells the funds in their portfolio that was in the bottom half of returns for their peer group over the prior 3 year period
  • Proceeds from the sales were invested in the top 20 performing funds in the specific peer group over the past 3 years

Results are below:


In every case, investors would have been better off just going with a buy and hold strategy rather than trying to get out of the losers and move the proceeds into the winners.  This is just more evidence that we are our own worst enemy when it comes to investing.  It is important to remember these facts the next time you are removing a fund from your portfolio because it hasn’t performed well.


Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.