How Does a Roth In-Plan Conversion Work? (2024)

A Roth in-plan conversion lets you take a distribution that is rollover-eligible from your 401(k) plan and roll it over to a Roth account in the same plan. The Roth in-plan conversion can be a valuable tax-saving strategy, if used correctly. It can also help high-income taxpayers legally avoid the contribution limits placed on income. Here’s how it works.

A financial advisor could help you optimize your retirement investments to minimize your tax liability.

How Does a Roth In-Plan Conversion Work?

A 401(k) in-plan Roth conversion allows the participant in the 401(k) the flexibility to transfer the rollover-eligible portion of the 401(k) to a designated Roth account within the same plan. The beauty of an in-plan Roth conversion is that the money can grow tax-free, as opposed to tax-deferred, for years or even decades if you follow the Roth in-plan conversion rules.

One rule is that the conversion of this money is a taxable event. Taxes have to be paid on the returns on contributions and on any pre-tax contributions that are included in the in-plan conversion. The owner of the account must report the taxable portion of the conversion as taxable gross income for the tax year in which the conversion was made. The taxable income is not subject to the usual 20% withholding or to the 10% mandatory tax penalty.

A second rule mandates that you are vested in the Roth account for a minimum of five years. Otherwise, the Roth account is not available for an in-plan conversion.

When Is a Roth In-Plan Conversion Helpful?

If you are young and in a lower tax bracket, a Roth in-plan conversion or several conversions could be a reasonable strategy to try to lower your tax liability. If you anticipate future tax rates to be higher than they are currently, this is also a reasonable tax strategy to undertake. Start making Roth in-plan conversions since you pay taxes on the conversions at your current, ordinary income tax rate. It will be far cheaper for you to take this strategy than paying taxes on conversions later at a higher tax rate. Remember that you have to be vested in the Roth account for five years. You would accumulate decades of tax-free money for yourself, a spouse or your children.

If you have deductions, like high medical expenses, that would allow you to itemize your deductions during the tax year that you take a Roth in-plan conversion. This will make the conversion even more financially wise for you since the itemized deductions would help offset the tax liability.

A Roth in-plan conversion also works if you are a high net worth individual and you don’t anticipate needing your retirement savings. You can make a Roth in-plan conversion and your money can grow tax free for years or decades as long as you follow the rules. If you are still earning money at age 72 1/2, you can continue to contribute to your Roth account.

Another situation when a Roth in-plan conversion might make sense is if you anticipate moving to a state with higher income taxes during the next tax year. If your retirement portfolio has been subject to market movements that have lowered its value during a tax year, it might be a good time for a Roth in-plan conversion since your tax liability won’t be as high.

When Not to Take a Roth In-Plan Conversion

If you are a high-income individual and you are nearing retirement, a Roth in-plan conversion may not make financial sense. You have to look at your tax bracket now and your anticipated tax bracket after retirement, including all other sources of retirement income like Social Security, t0 determine whether you should make a Roth in-plan conversion. You would then only do so if your tax bracket is expected to be higher in retirement.

Another instance when you don’t need to do a Roth in-plan conversion is if you don’t have enough extra money outside of your retirement plans to pay the taxes on the conversion. Otherwise, any tax savings you realize after retirement on the conversion will not outweigh having to produce the money to pay a huge tax bill now.

Possible Effects of the Proposed Build Back Better Act

The House of Representatives has passed the Build Back Better billbut it remains stalled in the Senate. As the bill is currently written, Roth in-plan conversions could be impacted. However, since the deadline for the bill’s enactment, December 31, 2021, has come and gone, and because the bill may be significantly changed by the Senate, it’s impossible to know what will happen with Roth conversions at this time. Though it is important to be mindful about legislation that could make changes to your retirement.

Bottom Line

A Roth in-plan conversion is a strategy that retirement investors can use to limit tax liability and generate increased tax-free income for the future. While a conversion could help you save money, you should also note that there are times when it may not benefit you financially and you may want to consult a financial advisor to see how it fits into you overall retirement strategy.

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