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The 411 on Roth 401(k) conversions

A taxing decision

Once you're eligible for converting to a Roth 401(k), a second hurdle emerges: paying taxes on the conversion.

Taxes must be paid because contributions to a 401(k) are made on a pretax basis. Contributions to a Roth 401(k) are made after taxes.

Therefore, moving money out of the regular 401(k) and into the Roth 401(k) is a taxable event. Tax is owed on the entire value of the conversion -- contributions and earnings -- in the tax year the conversion is done.

And there's the rub: Workers will need a bundle of cash to pay Uncle Sam to convert.

"You really need to have money from another source to pay the taxes. If, in fact, you take the money out of the plan to pay the taxes, you have taken a distribution which is taxable to you," says Beth Gamel, CPA and executive vice president of Pillar Financial Advisors in Waltham, Mass. Translation: You'll pay taxes on the money that you withdraw for the purpose of paying taxes.

Paying the tax with funds from the employer-sponsored plan lowers the amount you have saved for retirement and can diminish the benefit of converting to a Roth.

Other considerations

Participants under age 59½ in plans offering the option of converting employer contributions would want to avoid paying taxes with funds from their 401(k), even if their plan would let them get the money out, as there would be a 10 percent penalty on the early distribution in addition to taxes owed.

Timing may be important when it comes to converting from a 401(k) to a Roth. If the market is soaring and your investments have increased in value, more taxes may be owed on the earnings.

"This law only passed in the fall and the market has gone up a lot, so if your plan is at a really high level you might be paying a lot more in taxes than if you had done it last January," Gamel says.

Unlike a Roth IRA conversion, workers can't change their minds after pulling the trigger on the rollover. Participants in a 401(k) do not have the option of recharacterizing their 401(k) conversions.

"With the traditional IRA to Roth IRA conversion, if you see that the market goes down precipitously between now and when you have to file your tax return, you can recharacterize, or get out of it -- basically saying, 'Stop the clock! I didn't really do that conversion and I'm putting all my money back into my traditional IRA,'" says Gamel.

No such option exists for 401(k) conversions; workers will have to divine the best time to do their conversion.

Despite the burden of paying a mint in taxes in one year, converting to a Roth 401(k) can be advantageous for some workers.

Aside from tax-free withdrawals in retirement, Roth 401(k)s have another advantage. Unlike Roth IRAs, which have no required minimum distributions, Roth 401(k)s do require that you take distributions by age 70½. But you can get around this rule by directly rolling over your Roth 401(k) to a Roth IRA when you leave your employer. That way, retirement money that doesn't get used up in this lifetime can be passed on to heirs in the future.

For more information about Roth 401(k) plans, see Bankrate's story, "Roth IRA, 401(k): What's the difference?"

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