June 30, 2011

An employer sponsored 401k retirement savings plan is a great tool in your quest for a secure retirement. Of all the retirement accounts available for most investors — 401k/403b, Traditional IRA, Roth IRA — the traditional 401k has the highest annual contribution limit at $17,500 for those under age 50. (You can check out our comparison of these contribution limits ). Using a 401k to save for retirement is a lot easier for the average worker since you normally fill out the paperwork when you are first hired at your employer. Many employers automatically enroll their employees in their retirement plan at a 3% contribution rate; although you may want to consider changing the contribution amount.

In contrast, opening a Traditional IRA or Roth IRA takes some (simple) additional steps. You have to identify a broker to hold your Individual Retirement Account. You have to select some mutual funds to invest in. You have to set up automatic contributions or remember to manually send in your investments every month. Simple steps, but for the new investor it can be overwhelming so many choose to stick with a 401k plan until they start maxing out the contribution limit.

Do You Have a Roth 401k?

What many people do not realize is there are now two types of 401ks: the traditional, tax-deferred version and the new Roth 401k version. We’ve told you before that a Roth 401k may be the best of both worlds because you get the benefits of a Roth IRA with the ease of use of an employer-sponsored retirement account. About 30% of employers offer a Roth 401k option, but many people are unaware there is a choice to be made. Check with your human resources department to see if you can choose between the two.

New Roth Option? Consider Conversion

The Roth 401k was not legislatively written into permanent existence until 2006 with the Pension Protection Act of 2006. It had existed before then, but the account type was slated to expire at the end of 2010. With this type of account being so new, many firms are just now getting around to offering the Roth as an option. If you have been diligently saving for retirement with your employer’s plan before they offered a Roth 401k, you may be able to convert to the new option. Even if you can’t convert you can begin funneling your new investments out of each paycheck into the new 401k account by either changing your investments online or through your HR department.

How to Convert to a Roth 401k

If you want to convert your Traditional 401k to a Roth 401k, you need to take the following steps:

1. Check if you can convert

To start, know that not every company will allow you to convert your existing 401k balance to a Roth 401k. You need to check with your employer to see if this is an even an option. If not, just change your contributions so that new investments go into the new type of account rather than your original 401k.

2. Calculate income tax due

As with IRA conversions. you will owe income tax on the amount you are converting from a tax-deferred investment (Traditional 401k) to a post-tax investment (Roth 401k). You may need to speak with an investment adviser to accurately calculate the tax hit you will take in the year of the conversion, but you can estimate on your own. If you are in the 25% marginal tax bracket, just multiple the amount you converting by 25%.

3. Pay taxes outside of the 401k funds

After you calculate the income tax cost of converting, aim to have those funds set aside separately from the amount you are converting. You don’t want to convert a 401k with a $10,000 balance and end up with a Roth 401k with a $7,500 balance. Try to pay for the conversion with cash outside of your retirement account. And remember, you have until you file your taxes to come up with the cash. If you know you’re going to convert in January, you have until April of the following year to save up money. Add a line item to your budget that divides out the total needed by the number of months left until you file your taxes, and save for it monthly.

4. Complete the conversion

Once you have funds lined up to pay for the conversion, take the necessary steps to convert to a Roth 401k. Your employer or the plan company can provide the specific details on how to convert your account as it will be different from company to company.

5. Enjoy a tax-free retirement

That’s it! Continue to contribute to your new Roth 401k, stash extra money into a Roth IRA, and enjoy a tax-free retirement.

This article is by our Senior Editor, Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.