Fiscal Cliff Deal Hides a 401(k) Bonus
Jan 10th 2013 6:00AM
Updated Jan 11th 2013 4:47PM
But here's something to help soften the blow: Buried deep in the American Taxpayer Relief Act is a provision that lets a lot more workers convert their traditional 401(k) savings account into a Roth 401(k).
Drawing a blank?
Unlike a traditional 401(k), which people contribute to now and only pay taxes on withdrawals in retirement, a Roth 401(k) does just the opposite. Workers pay today's tax rate on their contributions, then are able to withdraw them tax-free in the future.
The Roth 401(k) has been around for more than a decade, but old tax laws blocked workers younger than 59½ from making the switch. Thanks to the new deal, that little stipulation will be gone in a few months, and the government is banking on the fact that they'll pocket a ton of new tax revenue when workers scramble to convert.
Now, you've just got one question to answer: Should you convert?
First of all, this requires a bit of guess work, which is why the answer is different for everyone. If you think you'll be in a higher tax bracket later in life, then it makes sense to convert to a Roth 401(k) now, pay lower taxes on your money at your current rate and then enjoy it tax-free later in life.
That's why most finance experts push Roth IRAs and 401(k)s for young workers, since they typically will move up in their careers and earn more with time.
In his book, "Worth It ... Not Worth It?," personal finance journalist Jack Otter sums it up nicely:
By making the maximum contribution to a Roth you are saving more money for retirement than if you max out a traditional IRA. Why? Because you are paying the tax now, and you'll get to keep 100 cents of every dollar in that account. With a traditional IRA, you'll have to give 10 or 20 or 25 cents of every dollar to Uncle Sam as you make withdrawals.
On the other hand, there are workers who shouldn't bother converting -- namely, those who expect they'll be in a lower tax bracket when they retire than they are today.
"It's a common concern that keeps some IRA owners from making the switch. "Can you imagine someone has a $300,000 IRA and right upfront they're giving up $75,000 of that IRA?" chartered financial consultant Mike Piershale, retirement expert and president of Piershale Financial Group, told BI. "[A Roth IRA conversion may] look good on paper when you're running a pure math calculation but in the real world, a lot of things happen."
To that end, the answer may be a partial conversion. So long as this new law sticks for a while, all workers will be able to convert a Roth each year. Calculate yourself (or with the help of an expert) how much you can afford to pay in taxes today, and then slowly move over funds annually until you're satisfied.