Last Updated on August 14, 2020
Over $7 Billion dollars…with a capital B. That’s how much money Americans lost track of in the form of retirement savings in 2015. Whoops. If you are one of those individuals who may have forgotten about your employer sponsored 401(k) from a previous job, now’s the time to consider whether or not converting your old 401(k) to a Roth IRA makes sense. It won’t be the right decision for everyone, but it’s a silver lining of an opportunity in a turbulent market.
Not sure if you have an old 401(k)?
If you’re not sure whether or not you still have a retirement account with a previous employer, you’re in good company. Whatever the circumstances are when you leave a job, there’s plenty of decisions that require your attention. Many of us utilize the out of sight, out of mind mentality with our retirement accounts, and that makes them even more likely to be forgotten. Luckily, you have a few resources at your fingertips to help you hunt down that information.
Start by reaching out to your former employer directly. Chances are they might be trying to get a hold of you too. If that doesn’t work, check out the National Registry of Unclaimed Retirement Benefits or the US Department of Labor’s Abandoned Plan portal. Even if you don’t plan to convert your retirement account, it’s essential that you take back control of those assets. If nothing else, make sure you review the fees and structure of your plan to ensure it is aligned with your retirement goals and strategy.
401(k) vs. Roth IRA
Before we dig into the reasons why converting your old 401(k) could be in your best interest, let’s briefly clarify the differences between these two types of accounts.
A 401(k) is a very common type of employer-sponsored retirement account. Like many other types of retirement accounts, there are annual contribution limits, and you must reach a certain age before you’re able to start withdrawing funds without penalty.
One of the reasons 401(k)’s are quite popular is because employers can provide matching contributions. For you, that means “free” money is going into your retirement account. 401(k) Roth options do exist, but they are not as common. Before you think about converting anything, make sure you understand what type of 401(k) account you have.
A traditional 401(k) is funded with pre-tax dollars, typically taken directly out of your paycheck. Pre-tax investments allow you to put more money into an account upfront, harnessing some additional growth early on. However, both your principal investment and earnings will be taxed when you start taking withdrawals.
A Roth Individual Retirement Account (Roth IRA) has similar strengths we typically associate with a 401(k). There are annual contribution caps and limitations on taking withdrawals from the account prior to a certain age. Additionally, Roth IRA’s are considered tax advantaged accounts, so there are income limitations to be wary of.
One of the biggest differences between a Roth IRA and a traditional 401(k) is that you contribute post-tax dollars to a Roth account. That may seem less attractive, but there’s a pretty big upside. Since you’re investing post-tax dollars into a Roth IRA, your withdrawals will be tax free – both the principal and the earnings.
So what is a Roth IRA conversion?
A Roth IRA conversion is simply changing your retirement account from one that is tax-deferred to one that is tax-exempt. Unfortunately that does not mean that you’ll get out of paying taxes. You didn’t pay any taxes on the money that went into your old 401(k), and Roth IRA’s require contributions to be already taxed dollars. Completing this type of conversion is considered a taxable event, so you will pay taxes in the tax year that you changeover your retirement account. You won’t receive a tax bill immediately upon executing the conversion, but you will likely owe taxes when it comes time to file your tax return.
Does it have to be an ‘old’ 401(k) to convert?
Does it have to be an ‘old’ 401(k) from a previous employer for me to be able to convert it to a Roth IRA? Not necessarily. However, it is much less likely that you’ll be able to convert a 401(k) to a Roth IRA with a current employer. All plans differ on the details though, so if nothing else it may be worth your time to ask your plan administrator if that’s a possibility for you.
So why is it a good idea to consider converting your account right now?
The average 401(k) is down about 19% right now. I know that’s a painful figure to read – and most of the time the best thing to do is keep your head down and stay the course. Younger investors typically have more stock-heavy (riskier) investment portfolios, so it’s likely those accounts are down even more than 19%.
So here’s where the opportunity lies. Because 401(k) accounts are down right now, the amount of taxes that you would owe to convert your account to a Roth IRA are much less than they would be in a good market.
For example, the average 401(k) balance for a 30-39 year old is $42,400. Let’s say that you are 34 years old and your income bracket places you at the 24% tax level. If you converted all $42,400, you’d pay around $10,176 in taxes. If we assume your 401(k) is down the average 19%, it’s now worth about $34,344. That means you’d only pay roughly $8,243 in taxes. That’s a savings of nearly $2000.
Tax savings are just a tiny fraction of the benefit
This Roth Conversion Calculator shows exactly what your retirement account would look like at your designated retirement age. It includes a direct comparison between your 401(k) with and without a Roth IRA conversion.
Below is the output for all of the aforementioned criteria. In the bar graph, you’ll notice the first (medium blue) column which shows the total amount your account would grow to (with no other contributions) in a Roth IRA. If you converted your $34,344 from a 401(k) to a Roth IRA, it would grow to $279,736. That’s over a quarter of a million dollars that you will never pay tax on again.
In comparison, the middle (dark blue) column represents how much after-tax money would be available to you if you left your $34,344 in a 401(k). By this calculation, you would end up $223,789. That’s $55,947 less than what you’d earn by converting to a Roth IRA.
The third (light blue) column shows you what your retirement account could look like if you were to keep your money in a 401(k) and also invest what would have been an $8,243 conversion tax bill. This a great option if you’re able to throw that extra money into the market. But you’ll notice it’s still $6,494 less than what you’d make by doing the conversion.
It’s painful news to hear that the average 401(k) is down by 19%. Fortunately, with hard times comes opportunity. In this case, it’s an opportunity to consider converting an old 401(k) into a Roth IRA for some serious tax savings and growth opportunities. Converting a 401(k) to a Roth IRA won’t be the best move for everyone. Meeting with a professional financial advisor to go over your specific situation will be your best bet to determine if this is something you should consider. However, if you’ve got a 401(k) from a previous employer that is more aggressively invested in stocks and you’re able to pay the conversion tax, right now may be one of the best times to consider converting that account into a Roth IRA.