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Should I or shouldn't I: A Roth 401(k) conversion

(MoneyWatch) Many 401(k) plan service providers are sending announcements to plan participants regarding the availability of Roth 401(k) In-Plan Conversions within their employer's savings plan.

Recent regulations now allow participants to convert some or all of their pre-tax balances within their plan to Roth type savings. Although such a conversion would be immediately taxable, depending on your individual circumstances, this could be beneficial to you over the long-term. Roth type accumulations in your 401(k) account can be a good thing. Roth type funds allow for greater flexibility with regard to your tax strategy down the road in retirement by giving you a source of tax-free funds to withdraw from your account when you need it.

Previously, Roth in-plan conversions were available only if you underwent a "distributable event", meaning you had to become eligible to take a distribution from the plan. Now, if your plan allows, you can convert some or all of the pre-tax 401(k) savings you currently have within your 401(k) plan to Roth 401(k) savings regardless of whether you become eligible to take a distribution.

Roth 401(k) Basics

Roth 401(k) contributions and their potential earnings have a unique advantage: the Roth source money grows tax-deferred and these funds can be withdrawn tax-free if you are at least age 59 1/2 and have had the Roth 401(k) account for at least five years.

But before converting any pre-tax 401(k) savings to Roth 401(k) savings within the Plan, plan participants should carefully consider some important consequences.

Conversion taxes will apply to funds converted from a pre-tax 401(k) to Roth 401(k). In most cases, converting from pre-tax to Roth savings is a taxable event. If you convert, you may be subject to federal, state, and local taxes on all or part of the converted amount. The money that you convert to Roth 401(k) will be taxed in the year you make the conversion. If you have not experienced a distributable event (such as termination of employment) or otherwise become eligible for an in-service withdrawal then you will not have access to use the funds in your plan account to pay the additional taxes due on the conversion. Therefore, you'll have to pay any taxes due with funds from outside the Plan.

If you do have access to your Plan savings due to a distributable event and wish to withdraw money from your 401(k) plan account to pay the conversion tax, you will owe regular income taxes on the withdrawn amount and the conversion tax on the converted amount. If you're younger than age 59 1/2, an additional 10% federal penalty tax will apply to the withdrawal. Because of these drawbacks, I strongly suggest that people considering a Roth in-plan conversion do not go this route.

I am generally not a fan of Roth in-plan conversions. First, because the amount you convert will be added to your taxable income, this additional income could cause more of your income to be taxed in a higher income tax bracket. It's hard to justify when large balances are involved.

Second, you cannot undo a Roth In-Plan Conversion. Unlike a traditional conversion to a Roth IRA, a Roth in-plan conversion cannot be unwound. So if after the conversion, the value of your account falls, you will still owe taxes on the full and higher value of your account that was converted.

As I mentioned, Roth 401(k) money can be very valuable in retirement. If your 401(k) plan offers Roth type contributions, then consider making Roth contributions instead of pre-tax contributions to gradually build up some Roth type funds in your 401(k) plan. But a Roth in-plan conversion requires careful consideration due to the sudden tax consequences. If this is something you are considering, then consult a tax advisor before you take action.

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