Should I convert my 401(k) to a Roth IRA?

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 below.

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...

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  • Ebeling, Ashlae. "The Big 401(k) Match Mistake." Jan. 13, 2012. (Feb. 21, 2013)
  • Hicken, Melanie. "More savers can convert to Roth 401(k) under fiscal cliff deal." CNN Money. Jan. 8, 2013. (Feb. 20, 2013)
  • Internal Revenue Service. "Retirement Plan FAQs regarding Required Minimum Distributions." (Feb. 21, 2013)
  • Keebler, Robert S. "Five Reasons Not to Convert to a Roth IRA." March 10, 2010. (Feb. 20, 2013)
  • Lankford, Kimberly. "FAQs on the New Roth Conversion Rules." Kiplinger. January 20, 2010. (Feb. 21, 2013)
  • Ning, David. "Why a 401(k) Trumps Roth IRA Contributions." U.S. News & World Report. June 6, 2012. (Feb. 21, 2013)
  • Spiegelman, Rande. "Saving for Retirement: IRA vs. 401(k)." Charles Schwab. October 10, 2012. (Feb. 20, 2013)
  • Updegrave, Walter. "Retire Without Taxes." CNN Money. September 16, 2008. (Feb. 21, 2013)