Attention Roth Flippers: Not So Fast

The U.S. Capitol in Washington, D.C. Photograph by0xA0Andrew Harrer/Bloomberg

January 3, 2013 - Tucked into the fiscal cliff tax package is a provision allowing 401(k) savers to convert some or all of their balance into a Roth 401(k) -- if your employer offers one, and not many do right now.

Why does this matter? With a regular 401(k) you pay taxes only when you withdraw the money at some point in retirement; presumably your tax rate will be lower because you no longer have income from a job. With the Roth variety, you pay the taxes upfront and future withdrawals are tax-free. Should you wind up leaving that money to heirs, it’s tax-free to them as well.

So what’s Uncle Sam’s angle in this? Well, they’re strapped for cash and legislators are betting that many folks will take this gambit. As this Bloomberg story points out , though, converting a $1 million 401(k) could cost you as much as $396,000 in taxes upfront. That's a pretty hefty premium to pay for the chance to earn tax-free gains down the road.

On the other hand, it may make sense for younger workers, especially if they haven’t accumulated much. Since they have a lot of working years ahead of them, they can recover any upfront costs. Plus their tax rates generally are lower because they aren’t earning as much, so the bite will be less. Rather than convert and pay the tax, however, savers could just put future contributions into the Roth 401(k). That way they don’t pay any more tax than they absolutely have to.

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