Dangers of Roth In-Plan Conversions

by Prof. Robert Bloink and Prof. William H. Byrnes

Roth 401(k)s are becoming more popular—and more readily available—with each passing year. Savers are naturally attracted to the opportunity to create a source of tax-free income during retirement without the hassle of establishing and managing a personal Roth IRA outside of the employment context. That said, Roth 401(k)s are governed by rules that can quickly become more complicated than employees tend to expect—especially when the individual later transfers their Roth 401(k) funds into an outside Roth IRA. One of those rules can subject the individual to an unexpected 10% penalty when the funds are transferred outside of the employer-sponsored plan. Understanding this often-overlooked “recapture” rule can allow the individual to plan ahead and potentially avoid the penalty tax.

Roth 401(k)s and Roth IRAs: Background