Should You Roth?

By most accounts the single best retirement savings plan is the Roth IRA. The main reason: Since you've already paid tax on the money going in, you don't have to pay taxes on accumulated gains when you withdraw money during retirement. But strict income limits have prevented highly compensated employees from opening an account. A $100,000 earnings cap on anyone wanting to shift money from a traditional IRA to a Roth also acts as a limit on the well-off.

Most investors know that a Roth conversion gold rush is set to begin in 2010, when the earnings limit on conversions will be lifted. The prospect has financial planners huddling with wealthy clients to figure out whether it pays to dip into IRAs, pay any taxes owed, and turn them into a Roth. Less appreciated is another pot of money available for older workers to convert: their employer-sponsored retirement savings plans.

If you are over 59 1/2 and still working at your company, you can withdraw the money in your employer's 401(k) plan without penalty and place it in a Roth. Your company's pension-plan documentation must allow for such an "in-service" distribution (while you're still employed), and a majority of large companies permit it. "The move can potentially save you a lot in future taxes," says Laurence Kotlikoff, an economist at Boston University and head of Economic Security Planning, a financial advisory firm.

But there's the rub—taxes. As with a conversion from a traditional IRA, you need to pay ordinary income taxes on the withdrawn money. A reasonable rule of thumb is that it's probably worth it if you have additional savings to tap for the tax bill. It does not make sense if you use withdrawn 401(k) money to pay the tax levy, since that reduces the amount that can grow, free of tax, in the Roth. It also probably doesn't make sense if you expect your tax rate to be lower in retirement than it is now.

Joel Larsen, a certified financial planner at Navion Financial Advisors in Davis, Calif., simulated a portfolio for a hypothetical 63-year-old worker in California. Among the more important assumptions in his calculations were a 33% federal and 9% state levy before retirement and a 28% and 4% tax rate afterwards. Larsen also used a 1.9% real rate of return on assets after inflation, a retirement age of 68, a life expectancy of 90, and a 401(k) worth $708,614 at age 68.

NUMBER CRUNCHINGIf the 63-year-old leaves his 401(k) alone, he can assume an estimated annual aftertax income of $28,910, without touching the principal. If he converts the account at age 63 and pays the tax from other savings (and subtracts an amount he reckons he might have earned on the money he used to pay taxes), his estimated aftertax income is $29,749. In other words, he should convert. "And I wouldn't stop contributing to the 401(k)," adds Larsen.

It pays to play with the numbers. If you have only enough savings to pay taxes on a partial withdrawal, for example, you can take out just a portion of the money. The benefits of an in-service withdrawal from a 401(k) to a Roth extend beyond income, too. For one thing, no minimum distribution is required at age 70 1/2 from a Roth like there is from a 401(k). And withdrawals from a Roth aren't counted in adjusted gross income, either.

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