Although you may be familiar with the employer-sponsored retirement plan known as the 401(k) plan, you might have never heard of a Roth 401(k). A Roth 401(k) functions just like a regular 401(k), except for different tax attributes. Depending on your financial situation now and in the future, converting your regular 401(k) into a Roth 401(k) could help you save more money toward your retirement.
Process & Eligiblility
Just like a regular 401(k), a Roth 401(k) is an employer-sponsored plan, meaning you must work for an employer that offers a Roth 401(k) to be able to convert it. And you can convert only regular 401(k) money that would otherwise be eligible for a rollover distribution. To qualify for a rollover distribution, you must either be older than 59 1/2 if you still work at employer holding your regular 401(k), or you must have separated from service. If one of these two conditions applies, and if you currently work for an employer that offers a Roth 401(k), you may convert your regular 401(k) into a Roth 401(k).
Taxation of Transfer
When you contributed to your regular 401(k), the Internal Revenue Service allowed you to exclude your contribution from your income -- in other words, your 401(k) contributions were deposited on a pretax basis. With a Roth 401(k), all contributions must be made with after-tax money. As a result, any money you convert from your regular 401(k) to a Roth 401(k) will be fully taxable as ordinary income. Because a large conversion can bump you into a higher tax bracket, you might want to speak with a tax adviser about staggering your conversion.
Taxation on Distributions
The main benefit of converting your regular 401(k) to a Roth 401(k) is the ability to take tax-free distributions in retirement. You can withdraw both contributions and earnings tax-free after you reach age 59 1/2 and have had your money in the Roth for at least five years. As with a regular 401(k), distributions before age 59 1/2 generally are not permitted, except in instances of extreme hardship. In those cases, your earnings will be taxable, and you will be subject to a 10 percent early-withdrawal penalty.
You can't escape mandatory distributions from your 401(k) simply by converting it to a Roth 401(k). Like a regular 401(k), a Roth 401(k) requires mandatory annual distributions once you reach age 70 1/2. However, you can avoid these mandatory distributions by converting your Roth 401(k) to a Roth IRA before age 70 1/2.
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