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.  

There Is No Such Thing As “Long-Term” In Tax Planning

I often read articles that talk about the virtues of long-term tax planning.  This could be in the form Roth IRA conversions, charitable planning or gifting strategies.  In general most of these articles are correct in their reasoning, but they tend to under-emphasize one important item:  what may happen to the tax code over the period they are planning for.  The idea for this post came after I have been reading both the President’s and Republican plan for altering the tax code.  Let me start by saying that both proposals have little chance of passing, but for those of us planning for future taxes, it should give us pause when arguing for long-term planning.  These proposals have significant changes to how income is taxed.  Changes in tax rates, deductions or the different types of income being planned for can have massive impact on tax planning in the future.  Those that believe we will be in the same brackets 20 or 30 years from now should revisit their history books.  For example, here is a chart of the top tax rate from 1913 to 2008:

Let this be a reminder that the tax code has underwent massive changes over the years and the odds are that this volatility will continue.  We have found the best tax planning can be done over short periods of time 1-5 years, where we have some more certainty around tax rates.  In addition, “slam dunk” strategies tend to be situations when clients are in zero or very low brackets and are expected to earn higher income in the future (or vice versa).  Those can be ideal times to plan for client’s taxes.  The only thing I feel reasonable certain about is that we all will be paying taxes in the future, and those that have/earn more, will pay more.  Other than that, it is hard to be certain about anything. 

Roth Conversions Under Attack

Yesterday, the House of Representatives narrowly approved Paul Ryan’s budget. While the Senate quickly rejected this bill, one of the provisions seems to have bi-partisan support, and that is reforming the tax code.  Many politicians have been advocating lower tax rates for all Americans in conjunction with eliminating deductions.  Ryan’s budget calls for the elimination of deductions and simplifying the tax code to two rates, 10% and 25%.  While this may be somewhat revenue neutral, it would simplify the code making it easier for everyone to complete their tax return.

Unfortunately, if something like this gets through Congress it could have a real impact on those taxpayers who have chosen to convert their IRA accounts to Roth IRA accounts over the past several years.  Let’s review how this works.  Currently, when I convert my IRA to a Roth IRA, I pay taxes today on the conversion amount.  In return, all of my IRA funds go into a vehicle (Roth IRA) that will be tax-free for the rest of my life.  Why would I do this?  Mainly, if I think either a) my income will be the same or higher in retirement and/or b) my tax rate will be the same or higher in retirement, then Roth IRA conversions could make sense.  You would pay taxes now at a lower rate versus waiting and paying taxes at a higher rate in the future.

This second point has been one of the driving factors why Roth IRA conversions have been gaining popularity.  The thought process is that the government has a debt problem and at some point tax rates will have to go up in order to pay for this massive debt.  Case in point, Congress allowed taxes to go up on wealthy Americans this year by not extending the Bush tax cuts.  But this budget proposal could nullify all of the value that individuals who converted to Roth IRAs thought they were gaining.  Tax rates would go down, not up, and deductions would be curtailed.  If I converted my IRA to a Roth IRA because I am currently in the 25% tax bracket and I will be in the 28% tax bracket in retirement, I would be extremely upset if the new tax law finds my marginal tax rate at 10%.  I will have essentially paid tax at a high rate to convert my IRA to a Roth IRA, only to find that if I had kept my IRA intact, I could have paid taxes at a much lower rate in retirement.

Tax planning well into the future is difficult because we have no idea what the laws may look like.  It would be wise for individuals to consider all of the risks (including legislative) when planning for the future.

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.