The Ins and Outs of In-Plan Roth Conversions

A 401(k) in-plan Roth conversion also called an in-plan Roth rollover (IRR) allows the participant to transfer the non-Roth portion of their 401(k) into a designated Roth account within the same plan. The upside of contributing to a Roth 401(k) from a participant perspective, is years of tax-free (instead of tax-deferred) growth as distributions in retirement from Roth accounts are free from federal income taxes.* However, the case for in-plan Roth 401(k) conversions can be complicated based on the participant’s age, tax bracket and balance of the account.

In-Plan Roth Conversions from the Participant’s Perspective

A conversion to a Roth 401(k) account is considered a taxable event and participants should be prepared to pay federal income taxes on pretax contributions and earnings associated with the rollover. These taxes should be paid with funds outside of the retirement plan. In general, the participant must report the amounts converted to a Roth 401(k) as taxable gross income for the year of the conversion. However, the taxable amount is not subject to the 10% penalty** for early withdrawal or the mandatory 20% withholding. With this in mind, participants should initially consider whether their expected tax rate will be lower or higher when they retire compared to their current tax situation when considering an in-plan Roth conversion.

When Time Is On Their Side

A conversion can work well for someone who is young and in a lower tax bracket. They will pay less in taxes now and will have years to accumulate their account assets tax-free in a Roth 401(k). The younger they make the move, the more years of tax-free compounding they get.

Leaving a Legacy

The in-plan conversion strategy can also be a smart move for high-net-worth individuals who won’t need all the money in their 401(k) for retirement expenses but want to grow it as an income-tax-free inheritance for their spouse and/or children. In addition, contributions can be made after age 70 ½, as long as the participant continues to earn income.

Maybe Not

For participants nearing retirement and in a higher tax rate bracket, a conversion may not make financial sense. Retirees often fall in a lower tax bracket as their income decreases, but this may not always be the case. Depending upon other sources of income, such as Social Security benefits and retirement plan income, retirees could have a higher-than expected tax bracket.

Plan Sponsor Considerations

Plan documents must be amended to allow for in-plan Roth conversions. Also, as active participants can only convert the portion of their account balance that would otherwise be eligible for a rollover distribution, the plan must contain in-service distribution provisions. Only vested amounts can be converted. Lastly, plan sponsors must keep careful records to satisfy 1099-R reporting requirements.

As your retirement plan resource, your ABG representative can help with any questions you may have. â–

*Provided the distributions occur after age 59 ½ and the account has been open for at least five years.

**A tax penalty may be assessed by the IRS if you take a nonqualified distribution from your Roth account within five years of the conversion.