At 66 Years Old and Ready to Retire: Considering Conversion to a Roth IRA with $745,000 in a 401(k)

At 66 Years Old and Ready to Retire: Considering Conversion to a Roth IRA with 5,000 in a 401(k)

Legally, it is never too late to make a Roth Conversion. The IRS will allow you to transfer eligible funds at any time, as long as you can pay the resulting tax bill.

For those who are retired or near retirement, the biggest question is whether it’s a wise decision to do a Roth conversion. On the one hand, a tax-free portfolio gives you much more control over your finances. On the other hand, you will have little opportunity to enjoy the benefits of after-tax growth.

A Financial Advisor can help you develop a retirement plan that takes into account taxes, cost of living, retirement accounts and more. Speak with an advisor serving your area today.

What is a Roth conversion?

A Roth IRA is what we call an “after-tax” IRA. retirement account. This is in contrast to more common tax-deferred accounts, such as a traditional IRA or 401(k).

With a pre-tax portfolio, you get a tax deduction for all qualifying contributions as you make them over your working years. This makes contributing to your retirement account less tax-expensive, allowing you to invest more with the same amount of income. Then, in retirement, you pay taxes on your withdrawals.

With an after-tax amount Roth IRA, you do not benefit from any tax deduction for eligible contributions. This means you are contributing money that you have already paid income taxes on. This makes it more expensive to contribute to your retirement account in the short term, effectively reducing the amount of income you can invest now. But in retirement, you pay no tax on withdrawals, including any returns generated by your investments.

A Roth conversion occurs when you move assets from one pre-tax account to an after-tax Roth IRA. You can only convert money in tax-deferred retirement accounts. Once you convert money to a Roth IRA, it follows the rules of an after-tax Roth account and benefits from all the tax-free growth. However, you will need to be prepared to pay taxes on this money, as it is now transferred to an after-tax account. On the bright side, Roth IRAs do not require RMDs, which can be a boon for retirees.

Unlike annual contributions, there are no limits on Roth conversion frequency or amounts. You can convert as much money as you want and as often as you want.

Roth conversions and taxes

The potential for tax-free growth makes a Roth IRA very valuable, but it comes with significant upfront costs. Since this money comes from a pre-tax portfolio, when you do a Roth conversion, you must add the entire converted amount to your taxable income for that year.

Using this example, let’s say you hold $745,000 in a 401(k). If you convert this amount into a single lump sum, you would add $745,000 to your taxable income for that year and, therefore, would have to pay state and federal taxes on the entire amount. While there are ways to handle this, most commonly by structuring your conversions to stay in lower tax brackets, there is no way to completely avoid paying taxes on converted funds.

Depending on the amounts involved, this can make a Roth conversion very expensive. Therefore, for households considering a conversion, the general rule of thumb is generally:

  • A Roth IRA is more valuable earlier in life, when you have more time to take advantage of its tax-free growth. It’s also very helpful to pay a lower tax rate now than you’ll pay on withdrawals, because it allows you to pay the current lower rate in exchange for avoiding the higher future rate.

  • A before tax wallet is more valuable when you currently pay a higher tax rate than you will pay in retirement, because the tax-deferred nature of the account allows you to save on your current higher rate in exchange for paying the lower rate in the future.

If you need help developing a retirement income plan, consider speak with a financial advisor today.

Doing a Roth Conversion in Retirement

There are many ways to manage your 401(k) when you retire, and converting the portfolio to an IRA is a common approach. In this process, you can choose to move your 401(k) to a traditional IRA or a Roth IRA.

However, all Roth IRA Contributions are subject to a recovery period. So if you’re contributing to a Roth IRA near or near retirement, make sure you plan on not being able to access that money for at least five years. If you withdraw before this date, you will be subject to a 10% early withdrawal penalty.

According to Tim Maurer, Chief Advisory Officer of the wealth management company SignatureFDa retirement conversion can sometimes be a good strategy.

“[E]arly in retirement may be one of the best times to consider a Roth conversion, when one’s taxable income is likely lower than in higher-earning years later in one’s career and may also be lower than later in one’s career. retirement when RMDs force retirees to take taxable income,” he said.

But, Maurer said, don’t make a conversion just for the sake of it. You need to have a goal and a strategy to justify the large upfront costs. Beyond “tax arbitrage,” which involves taking advantage of lower rates today versus higher rates later, Maurer suggests three main reasons why a current retiree might consider converting their savings:

  • You never need to take an RMD with a Roth IRA, which can further enhance the benefits of compound interest growth.

  • Diversifying income tax obligations is inherently valuable in retirement, especially for making larger purchases. If you want to finance something like a new car or a big trip, instead of risking a higher tax bracket by withdrawing extra money from a pre-tax account, you can tap into the tax-free Roth IRA. ‘tax.

  • Maurer also says, “There may be no better gift an heir can receive than a Roth IRA.” While a pre-tax retirement account balance also leaves taxes to your heirs, a Roth IRA leaves them with a clean, tax-free asset.

The question, he says, is how much value each of these questions has for you. It is important that each household determines for itself.

You can save significantly on a Roth conversion by staggering your conversions, which, given the five-year rule, might help anyway. Given this retiree’s relatively low Social Security income, he or she would have plenty of room for relatively small tax conversions each year.

Yet even accounting for the reduced taxes of a Roth IRA, this household is not expected to see much immediate benefit from converting its savings. Unless their tax situation changes significantly in retirement, or they have other assets, they are unlikely to receive a significant tax benefit to offset their conversion costs. A Roth IRA could be effective if, as Maurer suggests, they are looking for tax diversity or a solid estate plan. But it’s important to make this plan before physically moving money.

Roth IRA advice

  • A Financial Advisor can help you develop a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool connects you with up to three licensed financial advisors who serve your area, and you can have a free introductory call with your advisor to decide which one seems best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.

  • A Roth IRA is typically a self-directed portfolio, meaning you must select and balance your own investments. Even though everyone’s needs are different, here are some starting points.

Photo credit: ©iStock.com/LaylaBird, ©iStock.com/syahrir maulana

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