401k to Roth 401k conversion - help me use the right terminology to communicate

BigCountry

Level 2 Member
I currently have a 3% match at my work with 401k. My portion goes into Roth 401k, employer match goes into 401k.

Listening to Dave Ramsey the other day, and I heard him mention that you can once a year convert the employer match in the 401k over to Roth 401k by paying the taxes.

I had never heard of this before.

However, when I communicate with our fresh out of college plan administrator on how to do this, she is clueless as to what I'm talking about.

Can someone help me to know what specific form it is that I would fill out in order to do this? Also, is it too late to do this for 2016 401k match?

Thanks in advance
 

Matt

Administrator
Staff member
I currently have a 3% match at my work with 401k. My portion goes into Roth 401k, employer match goes into 401k.

Listening to Dave Ramsey the other day, and I heard him mention that you can once a year convert the employer match in the 401k over to Roth 401k by paying the taxes.

I had never heard of this before.

However, when I communicate with our fresh out of college plan administrator on how to do this, she is clueless as to what I'm talking about.

Can someone help me to know what specific form it is that I would fill out in order to do this? Also, is it too late to do this for 2016 401k match?

Thanks in advance
It's too late for 2016 taxes, but not too late for the 2016 money... Basically, if you convert Traditional to Roth you pay taxes on the amount that you convert, there's arbitrage here.

Traditional
  • Your 401(k) contribution reduces your W2, and therefore your taxes.
  • The employer match is invisible on W2 (by invisible I mean it doesn't add to income, but the amount will be shown in Box 12)
Roth
  • Your 401(k) contribution does not reduce your W2, and does not reduce taxes
  • Your employer match is taxable (they gave you more taxable money) it increases your taxes, but its still a net gain
Whether you are allowed to convert between Traditional and Roth 'within the plan' is not governed by the law, it is governed by the rules of plan document, and often contained in a part of the docs called the 'Summary Plan Description'. Legally, IRS wise, you can convert, but if the plan doesn't allow it, you cannot.

If it is allowed, here's how to play it:

You look at your tax bracket, after all your deductions etc, and you see how much you can 'top it up' by adding in new money to your income (the conversion is income). You rarely would want to convert the entire amount if doing so pushes you up a bracket.

EG let's say you are married, earn a salary of $80K, before any 401(k)Screen Shot 2017-02-02 at 1.38.41 PM.png

Because you are married, you get two exemptions, $4,050 each (another $4,050 for kids etc), plus a Standard deduction of $12,700 (or whatever if you itemize). So that is $8,100+$12,700 = $20,800.

$80,000-$20,800 = $59,200 so, for ball parking sake, if you had no other deductions, your income is $59,200.

From the chart above, $59,200 is squarely in the 15% tax bracket.

Now, let's bring in the 401(k). If you Roth, you don't drop the $59,200 down any further. If the company kicks in say, $1,000 of Traditional via matching, it is Invisible, you still are at $59,200.

If you convert the $1,000 to Roth, your income goes from $59,200 to $60,200. You are converting at 15% which is acceptable. However, if you had accumulated say $20K in the company match over the years, you'd be best served to convert it over two years, so you never exceed $75,900 (the starting point where you'd be taxed at 25%).

So, to answer your question 'is it too late for 2016' you can convert any or some of the money in the account, providing that the Summary Plan Description (SDP) allows for it. If you do convert, you will increase your salary, so look at your expected income for 2017, and top up only to the lower bracket, maybe you need to do $3000 a year for 5yrs, or whatever the amount that will be keeps you under the threshold.

This is called AGI manipulation, or tax bracket arbitrage. The last thing to be mindful of is that if you have the ability to claim any credits, such as the EIC, or Child Credits, that if you push your salary higher, you lose them.

FWIW, I generally recommend Traditional 401(k) accounts, and convert them to Roths later on, when income is more likely to be in the 10% and 15% bracket.

Ask your HR/Bennies person for a copy of the plan docs, including the SDP. The presence of both Roth and Traditional accounts within your plan would increase the chance that the conversion between the two is possible, but you also, depending on your tax bracket, might want to wait, and do the conversions later.
 

BigCountry

Level 2 Member
Thank you so much for the detailed response. That is really helpful. 2016 tax year our combined income went over $75k after deductions but under $100k so pushing us into another bracket shouldn't matter.

I located the SDP online (we use ADP) and I've read through the entire document but don't see where is it mentioned. Is there a specific section I'm looking for?

Thanks again for taking the time to write all of that description above.
 

Matt

Administrator
Staff member
Thank you so much for the detailed response. That is really helpful. 2016 tax year our combined income went over $75k after deductions but under $100k so pushing us into another bracket shouldn't matter.

I located the SDP online (we use ADP) and I've read through the entire document but don't see where is it mentioned. Is there a specific section I'm looking for?

Thanks again for taking the time to write all of that description above.
It depends. I would search for phrases like:

  • In Service
  • Conversion
  • Recharacterisation
Also, generally speaking, I would not do this in the 25% bracket. I would do this sometime between now and retirement, when one of you takes of work (a kid/back to college/something) or retires. 25% tax isn't cheap, and since it's a small amount in the Traditional in relation to the Roth I'd let it ride unless there were very specific reasons to expect a lot high income going forward, including your early years of retirement.
 

BigCountry

Level 2 Member
Thanks Matt.

But isn't paying taxes at 25% now better to have tax free growth for 21 more years?

Say it's $3,000 I'm rolling over

$750 taxes now versus that $3,000 being worth say $15k at 8% growth per year?
 

Matt

Administrator
Staff member
Thanks Matt.

But isn't paying taxes at 25% now better to have tax free growth for 21 more years?

Say it's $3,000 I'm rolling over

$750 taxes now versus that $3,000 being worth say $15k at 8% growth per year?
The way I look at it, the $750 'now' isn't a singular event. In your statement you are growing the $3K to $15K using compound interest. You need to also grow the $750 using compound interest.

So my thinking is that being able to put that $750 to good use today, added to the fact that you might be able drift that $15K into 10% or 15% buckets, is better. I'm against the entire Roth 401(k) and would suggest you use the money today that you defer to pay off your mortgage, and then get invested.

I wrote about it a month ago, but you were probably listening to Dave Ramsey instead of reading my blog :(

http://saverocity.com/finance/should-you-have-a-roth-401k-or-traditional-401k/
 
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