Earlier this week, I learned of another useful piece within The American Taxpayer Relief Act of 2012 – AKA the bill that averted the fiscal cliff. Congress has now made it easier to convert funds within your company 401(k) plan from Traditional to Roth status. Prior, only participants with access to the funds penalty free (people above age 59 ½) could do so, but now it’s open to all participants.
As a quick refresher, contributions to a Traditional 401(k) are tax-deductible today but withdrawals in retirement are completely taxable. In a Roth account, contributions are made with after-tax dollars (pay the tax today) and withdrawals are tax-free after age 59 ½. It’s the tradeoff between paying taxes today or in retirement. The kicker is that any amount converted to a Roth account will be added to your taxable income in the year of the conversion since you haven’t paid taxes on this money yet. This is exactly why they’re now opening this up and allowing more people to convert. Basically, the government needs money, and with a total of $17.9 trillion in traditional retirement plans in the US, they see an easy way to speed up tax revenues.
What I find amusing is that creating the traditional retirement account was one of the smartest things the government ever did from a tax perspective. They’ll happily forgo collecting taxes on your $X of contributions this year, because they know they’ll collect taxes on 6 or 8 times X when you withdraw the money in retirement. But I guess they don’t hold that view anymore. Then again, when does the government ever make a wise long-term decision? Their shortsighted decisions are our opportunities.
Since everyone’s tax and financial situation is different, it’s hard to make a general recommendation of whether or not this is a smart thing to do. However, keep in mind that the longer you’re able to allow the money to compound, the greater the benefit of using a Roth account will be – meaning if you have a good 20+ years until you’ll need to access the money, it’s probably worth paying the taxes on it today. More importantly, retirement planning is a lot easier when you’re able to remove an unknown variable. In this case that variable is what tax rates will be in the future. I personally don’t think they’ll be lower than they are today but they certainly might be higher. With a Roth, none of that matters because it all comes out tax-free!
For anyone considering the conversion, unless your opinion is that we’re in the early stages of a raging bull market in stocks, my advice would be to wait for the next bear market to roll around so the amount you convert (and pay taxes on) is less, but will then rally back tax-free.
Thanks for following!
Nick