Converting to Roth IRA Too Taxing? Consider Roth 401(k).

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Apr 12, 2010, 09:00 ET

SEATTLE, April 12 /PRNewswire/ -- This tax season provides a one-time-only-opportunity that helps spread taxes owed over two years for people who may want to convert some or all of their traditional IRAs into a Roth IRA. And, according to ShareBuilder 401k, a leading provider of 401(k) plans for small businesses, that provides some nice options for tax payers.

"Unlike traditional IRAs that are taxed once their holders start withdrawing the funds after reaching retirement age, the Roth IRA allows its holder to pay taxes now and then never again, earnings and all," said Stuart Robertson, general manager of ShareBuilder Advisors LLC which operates ShareBuilder 401k. This does assume you take no Roth withdrawals for at least 5 years to avoid tax penalties.

A Roth can make sense for those that expect to be in a higher tax bracket come retirement age or expect taxes in general to be meaningfully higher in the future than they are today.

So what's the catch with converting? More than anything it's the challenge of coming-up with the money needed to cover tax bills today versus down the road. In fact, experts recommend that if you want to convert to a Roth, only do so if you can pay the taxes with savings outside of your current IRA (in other words, cash they have on hand). No small feat for a lot of folks in a tough economy.

Still, it is possible for some. Thanks to a special two-year window to pay the taxes on the conversion done during 2010 it can be a great option for more folks than even next year – especially those who earn too much to contribute in a Roth IRA each year.

But, before hopping onto the conversion bandwagon, there are a few other ways to build-up Roth savings without paying a large upfront tax bill even with the 2010 provision. For example, if you're able to put money into a Roth IRA, and will for a while, that's likely a smarter choice – especially for those who may be challenged to find additional money for tax bills this year and next.

A likely better option -- no matter what your income -- is the Roth 401(k). The Roth 401(k) is a feature that any company with a 401(k) plan can add and offer to their employees. Here's how it works: participants can contribute up to $16,500 a year on a post-tax basis (aka Roth), or $22,000 if 50 years of age or more, and has no income limitations to contribute to unlike its Roth IRA cousin. In fact, you can decide how much you want to contribute tax-deferred or post-tax in your 401(k) to best manage your tax situation today and tomorrow.

To bring this more into focus, let's say you're considering to either do a $30,000 conversion from an existing IRA to a Roth IRA or build to a similar amount by contributing to a Roth 401(k). In this example you make $100,000 a year, are taxed at a rate of 25 percent, and currently contribute $10,000 a year to your 401(k) on a pre-tax basis. Here's what you're looking at:

By converting to a Roth IRA in 2010 you can pay all the $7,500 in taxes at the time you convert, or take advantage of the one-time provision to pay half of the taxes due in 2011 and half in 2012 ($3,750 each year) at tax time.

Now consider building into a similar position with the Roth 401(k) option. By contributing your $10,000 a year into the Roth 401(k) option versus pre-tax, it will take you three years to contribute $30,000 into the Roth. You will end up paying the same amount in taxes as you would in converting to a Roth IRA in this example in sum total, but slowly over a three year period. By spreading the tax payments over three years, you pay taxes on these contributions a little bit at a time from each paycheck. You will pay out $2,500 per year for these contributions in taxes, or about $96 per paycheck assuming you are paid every two weeks. It's a very affordable approach to build a Roth position that won't break your check book.

The 2011 out-of-pocket tax savings is $1,250 year and again in 2012 versus converting your IRA now and paying $3,750 per year.

Employees that work in a company without a Roth 401(k) should ask their employer to amend their plan to include it. This is typically a very nominal cost to business owners. If you're a business owner and don't have a 401(k) plan yet, you may want to consider adding one as the cost for those with less than 10-20 employees can be less than your personal and business tax benefits.

Converting to a Roth IRA can be a great idea, but for a lot of folks short on the cash to cover up-front taxes, an unrealistic one. Building into a Roth position is another option that may be a better fit.

About ShareBuilder 401k

ShareBuilder 401k provides easy, affordable and smart 401(k) retirement plans for small businesses, ranging from the self-employed to those with 250 employees. ShareBuilder 401k is a leader in providing 100 percent index-based ETF investments (plus a money market) in 401(k) plans. ShareBuilder 401k offers a suite of on-demand services that make it simple for employers and employees to open and manage their retirement plans online at www.sharebuilder401k.com. ShareBuilder 401k plans provide market-efficient investments and model portfolios that make it easy for employees to select the smart investments to help them get on track to meet their retirement goals. Customers can also take advantage of ShareBuilder 401k Consultants, Customer Success Managers, and Customer Care Agents to receive assistance in choosing and managing their retirement benefits.

ShareBuilder Advisors, LLC, is a registered investment advisor and a subsidiary of ING DIRECT.