Meet Joe Morgan and his daughter Samantha. Joe is 57 and Samantha just turned 27. Joe has worked for the same plastic manufacturing company for 35 years, first as a salesman and now as an executive. For decades, he has put money aside in his company's 401(k) plan for retirement, and now it's finally on the horizon.
Samantha graduated from medical school and just finished her residency. She's starting her first high-paying job as a real doctor and is excited to put her student debt days behind her. Retirement seems far away, but she knows it's never too early to start saving.
Both Joe and Samantha make more than $100,000 a year. Until 2010, only people who made less than $100,000 could convert a 401(k) retirement account into a Roth Investment Retirement Account (IRA), but those limits were lifted [source: Keebler]. Joe's financial adviser thinks he should convert all of his 401(k) savings into a Roth IRA immediately, so Joe calls Samantha to see if she wants to do the same thing. But does a Roth IRA conversion make sense for both of them? And most importantly, does it make sense for you?
First, let's define some terms. A 401(k) and a Roth IRA are two types of retirement savings accounts. In both cases, investors make contributions to the accounts while they are still working, and account managers invest those funds in a diverse portfolio of stocks, bonds, mutual funds and CDs. Ideally, the investments grow and the account holder has a nice nest egg to draw from during retirement.
The biggest difference between a 401(k) and a Roth IRA is when the money is taxed. With a 401(k), investors make contributions to the account before taxes. The 401(k) contribution is subtracted from Joe's paycheck before taxes are calculated. But when Joe retires, he will have to pay income tax on any money he withdraws from his 401(k).
Roth IRAs are the other way around. If Joe makes a contribution to a Roth IRA, he cannot deduct those contributions from his taxable income. In essence, he pays taxes before he invests. The upside of a Roth IRA is that Joe won't have to pay any taxes on the money he withdraws from his Roth IRA after retirement. That's why a Roth IRA is said to grow "tax-free."
As it turns out, converting from a 401(k) to a Roth IRA makes a lot of sense for Joe, but not Samantha. Find out why on the next page.
Reasons to Convert from 401(k) to Roth IRA
Remember that the biggest difference between a 401(k) and a Roth IRA is when the income is taxed. With a 401(k), taxes are deferred until after retirement. With a Roth IRA, you pay taxes now, but can take the money out tax-free when you are retired. For that reason, the decision to convert from a 401(k) to a Roth IRA depends your current income tax rate and the rate you expect to pay when you retire.
The rule of thumb is this: If you expect to be in a higher tax bracket when you retire, convert to a Roth IRA. Here's why. If you currently pay a 25 percent tax on your income, it's better to pay now and reserve your tax-free Roth IRA distributions for retirement, when you are in the 35 percent tax bracket.
But why would anyone be in a higher tax bracket after they retire? Let's use Joe as an example. Joe makes a nice salary, but for most of his working years, he had the benefit of several large deductions and tax breaks that lowered his taxable income. Joe is married, has four kids, and owns his home, so he always filed jointly, took deductions for each dependent, and deductions for mortgage payments. He also maxed out his 401(k) contributions every year (the 2013 limit is $17,500), further lowering his taxable income.
By the time Joe retires, he won't be able to take any of those deductions, and he won't be making contributions to his 401(k). Even if he's taking in less income after retirement — from savings accounts, investments and Social Security — he may have more taxable income, putting him into a higher tax bracket [source: Updegrave]. That's when tax-free Roth IRA distributions pay off.
There are other advantages with a Roth IRA conversion. With a 401(k), you are required to start withdrawing from the account at age 70½. There's no such required minimum distributionwith a Roth IRA [source: IRS]. If Joe wants, he doesn't have to touch the money in his Roth IRA at all. Joe has always wanted to leave something behind for his kids and grandchildren. With a Roth IRA, Joe's heirs can also withdraw money from the account tax-free after he's gone [source: Spiegelman].
Now let's look at why Samantha, Joe's daughter, might want to stick with a 401(k).
Reasons Not to Convert from 401(k) to Roth IRA
Unlike her dad, 27-year-old Samantha Morgan doesn't benefit from a lot of tax deductions. She's single, with no dependents and renting a one-bedroom apartment. After years of struggling as a low-paid medical resident with lots of student loans, she is finally debt-free and earning a doctor's salary, which puts her firmly in the 35 percent tax bracket.
One of the big reasons Joe Morgan decided to convert to a Roth IRA was because he expected to be in a higher tax bracket when he retired. Samantha, on the other hand, has good reason to expect to be earning considerably less, and paying less in taxes, after she retires. For that reason, it makes more sense for Samantha to make tax-free contributions to a 401(k), because she will pay a lower tax rate when she withdraws the 401(k) funds after retirement.
The other benefit of Samantha's 401(k) is that her employer, St. Jude's Hospital, matches a percentage of Samantha's 401(k) contributions. That's free money! The standard arrangement is to match 50 percent of employee 401(k) contributions every pay period up to the first 6 percent of salary [source: Ebeling]. But if Samantha wants to maximize the match, she needs to pace herself.
Let's say Samantha contributes 25 percent of her salary to her 401(k) every month. At that pace, she will reach the $17,500 maximum contribution limit in only 3.5 months. With a salary of $20,000 a month, her employer will match half of six percent, or $600 a month. That's only $2,100 after 3.5 months, but if she makes lower 401(k) contributions over all 12 months, she can stay under the contribution limit and get the full $7,200 in matching funds [source: Ebeling].
Another perk of Samantha's 401(k) is that it protects her retirement savings against creditors and lawsuits [source: Ning]. As a doctor, Samantha is exposed to medical malpractice and other lawsuits. She may also want to take out a loan in the next couple of years to open her own practice. A 401(k) has more built-in protections than a Roth IRA from creditors or lawyers looking to plunder liquid assets.
Of course, Samantha's income and tax situation could change for a number of reasons, like marriage, kids or home ownership. The benefit of sticking with a 401(k) now is that she can convert to a Roth IRA whenever she wants. The biggest reason to convert early is to avoid paying a huge lump sum in taxes. When converting to a Roth IRA, the IRS charges income tax on all tax-deductible contributions [source: Lankford]. So if you're switching from a 401(k), that means the entire balance is taxable at your current income tax rate. If Samantha waits too long to convert, the tax burden may outweigh the benefits of the switch.
The best advice is to talk to your tax professional about whether a 401(k) to Roth IRA conversion is right for you. For lots more information, check out the related HowStuffWorks links on the next page.
Author's Note: Should I convert my 401(k) to a Roth IRA?
I remember my first real job with health care benefits and this confusing thing called a 401(k). Retirement savings? I was 22 years old! The words "tax-deferred" meant about as much to me as "amortization chart." I probably would have ignored the 401(k) option entirely if my dad wasn't such an overzealous financial planner. He made me read the fine print in my contract to understand exactly what percentage of my 401(k) contributions could be matched by my employer. Then he broke out the calculator to ensure that I spread my contributions evenly across the entire year to get the most "free money" from my employer without maxing out my contribution limit too early. Thanks, Dad. Without you, I wouldn't be able to afford to retire until I was 92, which suddenly doesn't seem that far away...
- Ebeling, Ashlae. "The Big 401(k) Match Mistake." Jan. 13, 2012. (Feb. 21, 2013) http://www.forbes.com/sites/ashleaebeling/2012/01/13/the-big-401k-match-mistake/
- Hicken, Melanie. "More savers can convert to Roth 401(k) under fiscal cliff deal." CNN Money. Jan. 8, 2013. (Feb. 20, 2013) http://money.cnn.com/2013/01/04/retirement/roth-401k-fiscal-cliff/index.html
- Internal Revenue Service. "Retirement Plan FAQs regarding Required Minimum Distributions." (Feb. 21, 2013) http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Required-Minimum-Distributions
- Keebler, Robert S. "Five Reasons Not to Convert to a Roth IRA." Forbes.com. March 10, 2010. (Feb. 20, 2013) http://www.forbes.com/2010/03/09/roth-ira-conversion-tax-retirement-personal-finance-5-reasons-not-convert.html
- Lankford, Kimberly. "FAQs on the New Roth Conversion Rules." Kiplinger. January 20, 2010. (Feb. 21, 2013) http://www.kiplinger.com/article/retirement/T046-C001-S001-faqs-on-the-new-roth-conversion-rules.html
- Ning, David. "Why a 401(k) Trumps Roth IRA Contributions." U.S. News & World Report. June 6, 2012. (Feb. 21, 2013) http://money.usnews.com/money/blogs/On-Retirement/2012/06/06/why-a-401k-trumps-roth-ira-contributions
- Spiegelman, Rande. "Saving for Retirement: IRA vs. 401(k)." Charles Schwab. October 10, 2012. (Feb. 20, 2013) http://www.schwab.com/public/schwab/resource_center/expert_insight/retirement_strategies/planning/saving_for_retirement_ira_vs_401k.html
- Updegrave, Walter. "Retire Without Taxes." CNN Money. September 16, 2008. (Feb. 21, 2013) http://money.cnn.com/galleries/2008/moneymag/0809/gallery.Roth_guide.moneymag/index.html