While traditional IRAs and 401(k) plans have been around since 1974, the Roth IRA is just a baby, created in 1997. This relative newness, combined with Roth income restrictions, means that many people may reach retirement without the benefits of Roth IRA savings options. Retirees can convert traditional 401(k) accounts to Roth IRAs, but there are a number of factors to consider when deciding if it is the right thing for you.
The key distinction between a Roth plan and a traditional 401(k) is taxation. Money contributed to a Roth is after-tax, while 401(k) contributions are pretax. This means that when you convert a 401(k) to a Roth IRA, you must pay ordinary income tax on the account balance. Once you've completed the conversion, however, you never have to pay income tax on the account earnings, provided you follow the IRS rules. In addition, Roth IRAs are exempt from the required minimum distribution rule. You're never forced to withdraw funds, and you can take as much or as little as you need on your own schedule. Note that you cannot convert an annual required minimum distribution, but you can convert the rest of the account.
Most people are in a lower tax bracket during retirement than they were when they were working. This means that a Roth conversion is cheaper than it might have been before, though no less expensive -- proportionally -- than regular withdrawals from your 401(k). If you don't need the money you can let it grow, tax-free, and pass the tax-free savings on to your heirs. Traditional 401(k) beneficiaries must pay tax on each account withdrawal.
The biggest benefit of a Roth is the tax-free earnings. Converting in retirement means that your savings have less time to grow, and the earnings benefit is reduced. In addition, if you convert all of your 401(k) account, you'll pay tax on the full value. If you keep that money in the 401(k) or roll it over to a traditional IRA, you only pay tax on the amount you withdraw. Finally, if you do need your converted money, you'll pay a 10 percent tax penalty if you withdraw it before the conversion is five years old. This penalty applies even if you are over age 59 1/2 or qualify for another early withdrawal exception.
Before you convert your 401(k), think about your long-term plans for the money and your ability to pay the associated income tax -- both now, if you convert, and later, if you don't. Conversion calculators, available online, can help you determine your full tax obligation and potential conversion benefits. Remember that a Roth conversion is not an all-or-nothing proposition. You can convert your 401(k) in chunks over a period of several years, and you never have to convert the whole amount.