401(k) to Roth 401(k)

The law introduced last year allowing the ability to convert money in a 401(k) account to a Roth 401(k) within a plan where one is actively employed opens up new tax planning possibilities.

First of all, please check if your plan hasn't been amended to allow the in-plan conversions. While the law allows for these conversions, it doesn't compel your plan to offer the in-plan conversion feature.

Next, note that unlike a traditional IRA to a Roth IRA conversion, in-plan conversions cannot be "recharacterized,” the IRS term for "reversed" so you better be confident in your choice in making such a conversion.

Now comes your time to take a decision on executing in-plan conversion of 401(k) money to Roth 401(k). The criteria should be exactly similar to converting a traditional IRA to a Roth IRA. If you expect your tax rate to be higher in the future when you access your funds, you should consider a conversion. The idea is to pay taxes now so no taxes will be due later when the higher rate would apply. If a conversion makes sense for a family, generally the more that can be converted at today's favorable tax rate, the better. The lower your marginal rate is today, the better the odds a conversion will pay off.

Converted amounts and moneys withheld for taxes are all treated as taxable income. Taxable income from IRA's and 401(k)s are taxable income subject to a 10% early withdrawal penalty unless an exception applies. Amounts converted to Roth treatment qualify for an exception but amounts that pay taxes aren't. Therefore, for taxpayers younger than 59 1/2, the rate used to determine if a conversion might be a good idea jumps 10%, if the taxpayer is planning to pay taxes with 401(k) funds.