Skip to main content

An In-Plan Roth Conversion Can Help Manage Taxes on Your Nest Egg

The in-plan Roth conversion can be a powerful tool in building your retirement plan, but savers should get professional help to manage the tax risks.

Does your employer offer both a traditional and Roth 401(k) and does your employer allow you the opportunity to do what’s called an in-plan Roth conversion? That’s a tactic whereby you would convert some or all the money in your traditional 401(k) into your Roth 401(k). If so, it’s important to know the do’s and don’ts?

It’s worth noting that employer-sponsored retirement plans are not required to offer the option of an in-plan Roth conversion, though it is becoming more requested by younger participants, said Walter Pardo, the CEO of Wealth Financial Partners and WFP Tax Partners.

Get the paperwork right. If your employer allows in-plan Roth conversions, make sure you have the paperwork right. “Despite what custodians say, it may not be as easy as an online process,” said Leon LaBrecque, a certified financial planner with Sequoia Financial Group.

What’s your current tax status? Depending where you lie on the marginal tax rate scale, doing a Roth conversion might move you up that ladder, which might not be a good thing, said Thomas O’Connell, president of International Financial Advisory Group. “Again, depending on your outlook of tax rates, going from a 22% to 24% tax bracket might not be that big of a deal and could save you taxes in the future. But going from a 22% or 24% to a 35% will be a big deal and might defeat the whole purpose of doing the conversion.”

Pardo also notes that your contributions to the Roth will increase your taxable income. “Because it will be after-tax money, it will increase your taxes,” he said.

Note that you will have to come up with the money from another source to pay the taxes owed on the conversion, said Andy Ives, an IRA Analyst with Ed Slott and Co. “While a person can choose to pay the taxes on an IRA conversion with IRA dollars, which we do not recommend, you do not have that option with an in-plan conversion,” he said.

Measure twice, cut once. That’s the advice of Dan Moisand, a certified financial planner with Moisand, Fitzgerald, Tamayo. “The conversion cannot be unwound so it’s best to be careful with your tax calculations before executing,” he said. “There are lots of nasty little surprises that can come with higher gross incomes, in addition to putting you in a higher tax bracket than you would like.”

Charles Sachs, the chief investment officer of Kaufman Rossin Wealth, said Roth conversions are always a function on whether to pick up the conversion amount as ordinary income in a particular year. “With those who have had a drop in income this year it is a great strategy to consider,” he said.

Another adviser recommends getting professional help and crunching another set of numbers before executing an in-plan Roth conversion. “It is always a good idea to consider the cost and benefits of paying taxes now versus later,” said Larry Harris, director of tax services at Parsec Financial. “It certainly can make good sense to pay now but it never hurts to ask your adviser or tax professional to run an analysis of the cost and benefits of a Roth conversion. Generally speaking, the analysis involves computing the payback period for taxes paid on converted assets.”

Will your taxes be higher in the future? Next consider your views about tax rates. If you think your taxes will be higher in the future then an in-plan Roth conversion may be right for you, said Pardo.

Scroll to Continue

TheStreet Recommends

Others agree. Whether you are looking at an in-plan Roth conversion or individual Roth conversion, the first question you need to ask is this: Where are future tax rates going to be? “People are still under the impression that contributing money to a traditional 401(k) or similar plan ‘saves’ them money,” said O’Connell. “Like an accountant said to me just last week: ‘There’s no saving involved.’ So, if you think taxes will be higher in the future, you are probably better off at some level doing that Roth conversion now.”

Complicating the matter even more is the fact that taxation of Social Security benefits and/or triggering the income-related monthly adjusted amount (IRMAA) could require participants to pay higher Medicare premiums in future years, said Michael Peterson, a certified financial planner with Faithful Steward Wealth Advisors. “So, determining the advisability of an in-plan Roth conversion requires more than just an analysis of tax brackets,” he said. “It really requires a full-blown retirement income and tax projection in order to fully determine the pros and cons. Failing to do so can result in increased Social Security taxation and increased Medicare premiums that may dwarf the benefits of the in-plan Roth conversion.”

State of the stock market. Another thing to consider is the state of the stock markets, said O’Connell. “We are miraculously seeing record highs,” he said. “Doing a conversion today means paying taxes on a higher account value, and if the market heads downward, which it will at some point, you may be disappointed because there are no more recharacterizations. So, deciding at what level you do your conversion is important. People still think it is an all or nothing thing, but it isn’t. You may want to do it piecemeal over time to manage your tax obligation from the conversion.”

Don’t forget the five-year rule. A 401(k) is not an IRA and those accounts have separate clocks for the five-year year rule, said Moisand. “Now and then we see new retirees thinking they can get their Roth 401(k) tax free but can’t get earnings tax free after rolling to a Roth IRA because they didn’t already have a Roth IRA,” he said.

Noted Ives: If this is your first step into Roth within the plan, then your clock starts on January 1 of the year of the conversion. “However, it is important to note that the five-year clock on the in-plan conversion is separate from any clock on a Roth IRA.

The pro-rata rule. O’Connell also said the so-called pro-rata rule could affect any conversions you do if you have other qualified accounts. “If your plan includes after-tax contributions, can those be targeted for conversion while the pre-tax dollars remain unconverted?” asked Ives. “If the plan separately accounts for after-tax dollars and their earnings, this ‘tax-free’ conversion could be a possibility.”

RMDS could start at 72. JoAnn May, a principal with Forest Asset Management, said it’s important to remember that if your assets remain in your employer-sponsored plan, at age 72 you will be required to take a distribution from the plan, no matter if it is a designated Roth account or a pretax 401(k) account. “To avoid this, it would be best to rollover at least the Roth portion of the plan assets prior to turning 72 as Roth IRAs do not have a distribution requirement,” she said.

If you're over 59½, you might consider rolling your 401(k) to a Roth IRA, said LaBrecque. “Roth 401(k)s have RMD requirements, Roth IRAs do not.”

Inherited Roth 401(k)s. If you inherit a Roth IRA or Roth 401(k) and you are the spouse you can rollover to your own name, said Patricia Hausknost, a certified financial planner and instructor in UC Berkeley Extension's certificate program in personal financial planning. “If not, you’ll need to take the distributions within five years if a Roth IRA or 10 years if you inherit a Roth 401(k), assuming contributions began at least 5 years before the date of death,” she said.

Bottom line. “Don’t,” said Ives, “haphazardly dive into an in-plan Roth conversion without knowing the depth of the water.”

Others share that point of view. There is a lot to consider before executing an in-plan Roth conversion, said O’Connell. “Some of those considerations are just plain old objective math calculations, others are very emotional,” he said. “This is a big decision. Doing it correctly could mean literally thousands and thousands of dollars saved from taxes. Done wrong it can be an economic catastrophe for someone and their family.”