If investments in a 401(k) have lost money, can you use the current value to convert to a Roth?
Converting your 401(k) retirement account to a Roth IRA when the value of your investments are down is a compelling tax strategy since you will only pay taxes on the current value. Although there are some restrictions:
- You must be separated from your employer to roll your 401(k) into a Roth IRA. You may not do this if you are still working for the same company and/or employer, unless you’re already older than 59.5.
- Prior to January 2008, you weren’t able to roll your 401(k) into a Roth IRA. If you wanted to do so you had to open a traditional IRA then convert the traditional IRA to a Roth IRA. It all depends on your plan administrator.
Currently, most anyone can take all of their traditional IRAs and retirement plans and convert them to a Roth IRA. The amount you convert will be taxed.
You will want to do a rollover and not a distribution, otherwise your 401(k) provider will send you a distribution check from your 401(k), then they will hold around 20% for taxes. If you prefer a direct 401(k) rollover to a Roth IRA, you will want to indicate that you want a rollover and provide all the appropriate forms. If you do receive a distribution check, you will have 60 days to redeposit the check back into an IRA or convert to a Roth IRA.
If you employer offers a Roth 401(k), the rollover will be much easier. When you are converting one Roth product to another, there is simply no need for a conversion. You would simply roll the Roth 401(k) directly into the Roth IRA with the help of your plan provider.
Also, please consider the following before making the decision:
- Do you expect to pay higher taxes in the future.
- Roth IRAs use after-tax dollars, so you will have to pay taxes upfront on any funds you rollover. With a Roth IRA, your withdrawals will be tax-free.
- You want to take withdrawals at your own discretion. Traditional IRAs force you to begin taking withdrawals at age 70.5, Roth IRAs do not have the required minimum distribution (RMD).
- Keep in mind that if you do a Roth IRA conversion from a traditional IRA you may re-characterize your conversion if you decide to undo the conversion due to your investments going down even lower or if you do not have the funds to pay the taxes that year. When converting directly from a 401(k) to a Roth IRA the re-characterization is not an option.
Rolling your 401(k) into a Roth IRA, especially while your investments are down in value, makes sense but it is still wise to consult with your CPA and Financial Advisor to make certain taking into consideration your personal financial situation.
The first question that needs answering is "convert to a Roth where?" Does your current 401k allow Roth within it, or are you referring to withdrawing it from the 401k? I would personally request the 401k plan SPD (Summary Plan Description) and see what rules they have as options. I do this all day long for people, and you would be surprised with options are sometimes available. Inevitably the conversion to a Roth has many factors which will determine if it's the smart thing to do or not, this is not a no-brainer. Consult with a professional on this one.
If your 401(k) offers a Roth conversion provision, you can always convert the current value to a Roth. You won't benefit from a loss in any way, but, that isn't my primary consideration for a conversion to a Roth.
When you convert to a Roth when the market is down, you convert more shares to a Roth than you did when the account was higher, and so, this may be a valid strategy if it is worthwhile in your circumstance to pursue and pay the tax.
If you are still working at the company where the 401(k) resides, then you probably have to leave the 401(k) intact where it is. There are some 401(k)s that allow you to roll out into an IRA at certain ages, either 60, 62, or 65, but those are far and few between. If you are no longer working for the company, then yes, you can roll the assets into an IRA, either a Roth or a Rollover "Traditional" IRA. But if you do covert to a Roth, the entire amount you roll into the Roth is taxable as income. Since you received a tax deduction going in, it is taxable as income when distributed. A rollover to a traditional IRA would not be taxable until you make distributions from that IRA. But with the Roth, that is considered a distribution (conversion into the Roth), but then would not be taxable when taken from the Roth. So you either pay now or later. Planning is critical here, and they are not mutually exclusive. What I mean is you could split the rollover into both a Roth and "Traditional" Rollover IRA to spread the taxes over time.
Hope this helps, Dan Stewart CFA®