Piggy bank marked 401KDo you or don't you want to convert to the Roth 401(k) or a 403(b) by the end of 2010?

That's the hot retirement-planning topic of the year for anyone, especially those on the verge of retirement.

Timing-wise, the biggest attraction to converting is being able to spread the taxes you'll have to pay over two years -- 2011 and 2012 -- instead of having to cough up all that money at once. It's a one-time deal from Congress and the IRS, designed to encourage you to make the switch.The arguments for making the conversion from a money-management standpoint are these:
  • There are no income limits like there are with Roth IRAs, so you can make a big salary and still convert.
  • If this was a lousy year and you didn't make much money, paying the taxes on your current 401(k), if you can afford it without having to sell any of its assets, could be a smart move because once you retire, you can spend at will without giving any of it to Uncle Sam.
  • Getting tax-free income from a Roth is a gift that keeps on giving. Manage the income correctly and it could keep your taxable income low enough that you won't have to pay taxes on your Social Security -- a huge boon.
  • If your crystal ball tells you that after you retire, the federal tax rates are going to go through the roof, then hurry up and convert right away because taxes this year are attractively low.

But switching to a Roth 401(k) or 403(b) might not be for everybody. Here are a few reasons to leave your conventional workplace retirement account alone.
  • Only about one-third of employers are offering Roth 401(k) or 403(b) plans. Wednesday, Dec. 15, is the last day for a plan sponsor to make the decision to offer a Roth 401(k) or 403(b). Chances are if your employer hasn't already finished the paperwork, you're out of luck. If you have a solo 401(k), the deadlines are more generous.
  • In most cases you have to be 59 1/2 in order to make the conversion without paying a 10 percent penalty -- a really stupid move. Younger employees can make the switch if you have left assets in a former employer's 401(k) or 403(b) plan that you could potentially roll over. You also could roll assets that you have moved into your current employer's plan from a former employer's plan as long as they are being held separately. Another possibility if you are younger than 59½ crowd is distributions from a defunct defined-benefit pension plan that have been rolled over into your 401(k) or 403(b) plan.

If you decide you are eligible, then here are some financial considerations:
  • During the conversion period, your increased income could cut or even wipe out your eligibility for itemized deductions, personal exemptions and education-related tax credits. You might also trigger eligibility for the alternative minimum tax and that could be really expensive.
  • Almost all of the calculations that argue in favor of a conversion, make the assumption that the money that you will withdraw in retirement will be at your highest marginal tax rate. But the tax system in the U.S. is progressive. So unless you think that every year you live in retirement you will fill the lower tax brackets with fully taxable income from sources like a defined benefit pension, investments within a very large, traditional 401(k) and even Social Security, you'll be paying taxes at a lower rate than you will during a pre-retirement conversion.
  • Next, before you make the conversion, calculate what you'll owe in state taxes. In many states, people older than 65 don't have to pay state taxes on retirement income, and some states popular with retirees, such as Florida and Texas, don't have state taxes at all. So paying taxes to convert when you could wait and pay no state taxes may not make much sense.

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