What is a Roth Conversion and do I want one?
There are many types of retirement accounts. Two of the most popular ones are the Traditional 401k and Roth Retirement Account. The primary difference between these two types of accounts is timing of when you pay taxes on them.
Money that you put into a Traditional 401k is pre-Tax. You don't have to pay taxes on the money you put into a Traditional 401k; but you do pay taxes on that money and all it's earnings when you withdraw it in retirement. Money you put into a Roth is post-Tax. You do pay taxes on the money prior to investing it. However, you don't pay any taxes on any of the withdrawals in retirement, so all earnings are tax free.
So which is better? Unfortunately, it depends.......
If your tax rates increase between now and retirement, you are likely better off with a Roth Account. This would allow you to pay taxes at today's lower rates on just the principal of your investment. The Traditional 401k would postpone taxes until rates have increased, at which time you would be taxed on both principal and earnings at the higher rate.
But will my tax rate be higher when I retire?
If you invest your whole life and have millions producing interest, dividends and capital gains – you may very well be in a higher tax bracket when you retire than you are now. But there is a bigger variable at play – What will the government do to tax rates?
Nobody knows the future, but here are some points to consider:
- Tax rates have varied significantly over time:
1913: Highest bracket was 7%
1950-79: the highest bracket was over 70%
1980's: Highest bracket was 28% for 3 years
Now: Brackets are slowly increasing.
- The highest tax rates in history followed record high government debt created during WorldWarII.
- Government debt is now at a new all time high percentage of GDP, and brackets are slowly increasing.
If these historical data points and our current administration's direction lead you to believe tax rates may increase in coming years, then a Roth conversion becomes an even better idea. There is no way I can predict the future. I am personally in year three of a four year plan to convert all of my traditional 401k accounts to Roth.
A Roth conversion is the movement of money from a Traditional 401k into a Roth Retirement Account. It requires payment of taxes on the money moved, but does not create penalties normally associated with early withdrawal from a 401k. If you believe tax rates are increasing, then this move would allow you to pay taxes now at a lower rate, rather than later at a higher rate.
Check with your CPA or Investment Adviser and ask them if a Roth conversion is right for you. They can help you decide if it is a good idea as well as how much of your 401k you might consider converting.