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Investing & Retirement

Should You Convert Your Traditional 401(k) Into a Roth 401(k)?

8 Minute Read

Over the past few years, you might have received an email from your company’s human resources department introducing a new retirement savings plan option: the Roth 401(k).

More and more companies—especially large ones—are adding Roth options to their 401(k) plans. In fact, seven out of ten employers now offer this option to their employees.(1) If the Roth 401(k) is on the table at your workplace, that’s great news for you!

But if you now have a Roth 401(k) option, you’re probably wondering what to do with your existing 401(k). Is converting an existing 401(k) to a Roth the way to go? Or should you just leave it alone?

There are some things I want you to keep in mind before you make this decision, so let’s dive in.

What Is a Roth 401(k)?

The Roth 401(k) is a workplace retirement savings account that combines the convenience of a traditional 401(k) with all the benefits of a Roth IRA. It’s the best of both worlds!

There are some similarities between traditional 401(k) and Roth 401(k) options. Companies can offer a match through either, and these options also have a $18,500 contribution limit. But that’s where the similarities end.

The biggest difference between a traditional 401(k) and a Roth 401(k) is how your contributions are taxed. When you put money into a traditional 401(k), you’re using pretax dollars. That means the money goes into your 401(k) before you pay taxes on it. Those taxes are then deferred until you make withdrawals from your 401(k) in retirement.

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On the other hand, your contributions to a Roth 401(k) are made with after-tax dollars, meaning you invest that money in your Roth 401(k) after you pay taxes on it. It’s a little more expensive on the front end, but trust me when I tell you it’s worth it. Why? Because you get the benefit of tax-free growth on your contributions. So when you start withdrawing money at retirement, you won’t have to pay a single penny in taxes.

Whenever you can make tax-free growth part of your investment strategy, do it!

There is one important thing to remember about the Roth 401(k): Only your contributions grow tax-free. If your company offers a match, you’ll have to pay taxes on retirement income from the match side of the account.

Still, the Roth 401(k) is an amazing deal. It could literally save you hundreds of thousands of dollars at retirement. And yet, only 7% of workers are making contributions to their company plan’s Roth option.(2) That’s just sad, people!

If you’re just starting out with a company and they give you this option, take the ball and run with it!

Should I Convert My Current 401(k) Into a Roth 401(k)?

If you already have a traditional 401(k) at your current job and the company just introduced a Roth 401(k) option, converting that 401(k) into a Roth might sound like a good idea. But is a conversion your best option? It depends on your situation.

The main drawback of converting a traditional 401(k) into a Roth 401(k) is the tax bill that comes with making the switch. You’re going to have to pay taxes on that money because it hasn’t been taxed yet.

Let’s say you have $100,000 in your traditional, pretax 401(k) and you want to convert the account into a Roth, after-tax 401(k). If you’re in the 22% tax bracket, that means you’d be paying $22,000 in taxes. That’s nothing to sneeze at!

If you convert your 401(k) into a Roth 401(k), you need to have the cash on hand to cover the tax bill—no exceptions. Do not use money from the investment itself to pay the taxes. If you do, you’ll lose a lot more than $22,000. You’ll also miss out on years of compound interest, which is typically about 10%. So after 20 years, a $100,000 account could grow to be $148,000 more than an account with a $78,000 starting point because of compound interest.

There are also alternatives to a 401(k) conversion to consider. For example, you can leave your traditional 401(k) alone and start putting money from your paycheck into a new Roth 401(k) instead. That way, you don’t have to worry about taking a hit paying taxes now and still take advantage of the Roth’s tax-free growth later.

Here’s the deal: I want you to be careful as you think about transferring your retirement savings into a Roth 401(k). It might make sense for you if you can pay cash for the taxes without taking money out of your 401(k) and if you’re still several years away from retirement. If those scenarios don’t apply to you, you probably want to think about an alternative option.

But before you do anything, make sure you talk with an investing professional. They can help you understand the tax impact of a 401(k) conversion and weigh the pros and cons of each option.

Here’s How to Convert Your Traditional 401(k) Into a Roth 401(k).

The process of converting your pretax 401(k) into a Roth 401(k) varies from company to company, but here’s a general overview.

1. Find out if you’ll be able to convert your 401(k).

According to the IRS, in order to be eligible for a 401(k) conversion, the money must be vested.(3) All the money you put into your 401(k) is immediately vested, but your employer’s contributions are usually vested over time. Depending on the vesting schedule set up by the company and how long you’ve been there, your existing 401(k) might not be fully vested yet.

Companies sometimes have their own additional restrictions on who can convert their 401(k), so ask your employer if you are eligible.

2. Figure out how much you owe in taxes.

You can estimate those taxes by multiplying the amount you plan on converting by your income tax rate. When you get that number, set aside or come up with a plan to save up the cash you need to pay those taxes when tax season arrives without dipping into the money from your 401(k).

3. Check with your company for information about their conversion process.

They will be able to give you the forms to fill out. After that, you can enjoy all the benefits of a Roth 401(k)!

What Should I Do With an Old 401(k)?

You might have an old 401(k)—or several—lying around from previous employers. Transferring the money from a 401(k) to your new employer’s Roth 401(k) might seem like an appealing option. But just remember, you’ll get smacked with a tax bill if you go that route.

Rolling your old 401(k) into a traditional IRA is another way to go. You’ll have more control over your investments and will be able to choose from thousands of funds with the help of your financial advisor. Plus, you won’t face any tax consequences since you’re moving from one pretax account to another.

If you aren’t able to transfer your money into your new employer’s plan but think a Roth is for you, you could go with a Roth IRA. But, just like with a 401(k) conversion, you’ll pay taxes on the amount you’re putting in. If you have the cash available to cover it, then the Roth IRA might be a good option because of the tax-free growth and retirement withdrawals.

Talk to a Pro Before Converting Your 401(k).

Deciding whether or not to convert your traditional 401(k) into a Roth 401(k) is a huge decision. There are thousands of dollars at stake! You definitely don’t want to make a decision like this on your own.

An experienced investing professional can help you figure out the best way to handle your investment accounts in order to keep you on track toward your retirement goals. If you don’t understand something, ask questions. I don’t ever want you to make a financial move you don’t understand.

If you’re looking for an investing pro in your area, use our SmartVestor program! It’s a free way to connect with top-notch investing professionals who are ready to help you make the most of your retirement dollars.

About Chris Hogan
Chris Hogan is a #1 national best-selling author, dynamic speaker and financial expert. For more than a decade, Hogan has served at Ramsey Solutions, spreading a message of hope to audiences across the country as a financial coach and Ramsey Personality. Hogan challenges and equips people to take control of their money and reach their financial goals, using his national TV appearances, The Chris Hogan Show, and live events across the nation. His second book, Everyday Millionaires: How Ordinary People Built Extraordinary Wealth—And How You Can Too is based on the largest study of millionaires ever conducted. You can follow Chris Hogan on Twitter and Instagram at @ChrisHogan360 and online at chrishogan360.com or facebook.com/chrishogan360.

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