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Considering a Roth 401(k) switch

By Jennie L. Phipps ·
Sunday, November 7, 2010
Posted: 10 am ET

Converting from a traditional 401(k) or 403(b) to a Roth 401(k) or 403(b) can be a very good retirement planning move if you think that you are in a lower tax bracket today than you will be when you retire.

For instance, if you are unemployed and if you can afford to convert this year and spread the taxes over three years, your tax bill could be minimal. But there are other circumstances when making a pre-retirement conversion isn't a good idea because the conversion will make you look richer than you are and affect your eligibility for other tax benefits during years when you need them the most. If you're not careful during the conversion period, you could cut or even wipe out your eligibility for income-capped goodies, including:

  • Itemized deductions.
  • Personal exemptions.
  • Education-related tax credits.

Worst of all, you might trigger eligibility for the alternative minimum tax, the dreaded AMT, which can really be expensive.

Almost all of the calculations that argue in favor of a conversion, make the assumption that the money that you will withdraw in retirement will be at your highest marginal tax rate. But the tax system in the U.S. is progressive. So unless you think that every year you live in retirement you will fill the lower tax brackets with fully taxable income from sources like a defined benefit pension, investments within a very large, traditional 401(k) and even Social Security, you'll be paying taxes at a lower rate than you will during a pre-retirement conversion. My colleague Barbara Whelehan wrote about this phenomenon in an earlier retirement planning post about Roth 401(k)s.

Next, before you make the conversion, calculate what you'll owe in state taxes. In many states, people older than 65 don't have to pay state taxes on retirement income, and some states popular with retirees like Florida and Texas don't have state taxes at all. So paying taxes to convert when you could wait and pay no state taxes may not make much sense.

This isn't to say that converting your traditional 401(k) or 403(b) to a Roth 401(k) or 403(b) before you retire is always a lousy idea, but it's not a no-brainer and doing the calculations or getting expert help to do the calculations before you leap is a worthy exercise.

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