When it comes to retirement planning and taxes, there are often two ways to approach a question: first, can you do something, and second, should you do it?
For example, let’s say we have a household that is planning for retirement. Would it be wise for them to convert their 401(k) to a Roth IRA at 20% at a time to avoid taxes and RMDs? Technically, this is certainly allowed. You can do it.
Whether this is wise is another matter. In general, this plan will work better the younger you are and the less you currently earn. On the other hand, the closer you are to retirement or the higher your current income, the more likely it is not worth the conversion taxes. Like Aaron Cirksena, founder and CEO of MDRN Capitaltold SmartAsset: “You face unique challenges that are based on your own situation and that need to be considered.”
This is a question about your own finances, not a generic or one-size-fits-all approach. To find professional advice tailored to your situation, you can get matched with up to three financial fiduciary advisors free.
Converting Your Roth IRA to Avoid RMDs
Pre-tax retirement accounts, such as a 401(k)have a rule called required minimum distribution (RMD). This is the minimum amount you must withdraw from your portfolio each year starting at age 73. As with all pre-tax distributions, this is added to your taxable income for the year, which is the whole point. The IRS wants to make sure that you will eventually pay off your tax-deferred accounts.
Depending on your situation, this may disrupt your financial planning. Some households want to live off other income or assets, allowing tax-deferred accounts to continue to grow. Others simply don’t need the money and want to pass it on to their heirs. Whatever the reason, a required minimum distribution can increase your taxes and reduce this account.
This is where Roth conversions come into play.
Like all after-tax portfolios, a Roth IRA is not subject to RMDs. So, households trying to avoid minimum distributions often convert 401(k)s to Roth IRAs. You can do it at any age and for any amount. The only significant requirement is that the assets must come from a pre-tax portfolio, and the converted assets cannot themselves constitute a required minimum withdrawal.
Roth conversions have significant and immediate tax implications. Consider reviewing the best options for your situation with a Financial Advisor who is obligated to work in your best interest.
Roth conversions and taxes
A Roth conversion has two major drawbacks to consider.
First there is the five year rule. When you convert funds from a pre-tax portfolio to a Roth IRA, that money must stay in place for at least five years or until you reach age 59 1/2. While this isn’t an issue for most households, it’s still important to think about, especially if you’re planning to retire soon and will soon need this income.
Then there are taxes. When you convert assets to a Roth IRA, you include this amount in your taxable income for the year. For example, let’s say you convert $250,000 of securities from a 401(k). In the absence of special circumstances or other income, you will need approximately $54,547 on this transfer.
There are many ways to handle this tax event. When possible, for example, it’s best to convert a pre-tax account earlier in life. The longer you wait, the more that account will grow and the more taxes you’ll pay on those returns. It also helps to convert your money in stages. By converting less money each year, you can reduce your tax rates and the overall amount you pay.
For example, let’s say you have $1 million in your 401(k). If you convert this portfolio all at once, you will pay an effective federal tax rate of 32.52%, or approximately $325,208 in taxes. On the other hand, let’s say you convert $200,000 at a time. You would pay an effective rate of 19.2%, or $38,400 per year, for a total tax bill of $192,000.
Note that this estimate does not include applicable state or local taxes, growth in your portfolio, or other nuances. A fiduciary financial advisor can help you calculate math more accurately.
Should you convert your 401(k)?
So if you can convert your 401(k) to avoid RMDs and taxes, the real question is… should you? Let’s return to your example. Say you have a 401(k). Should you convert it 20% at a time, over five years, to a Roth IRA?
The answer, Cirksena said, is…it depends.
“It depends 100% on each person’s income situation and projected retirement income. In theory, yes, it makes sense to start limiting the amount of money we have in our retirement accounts before taxes. However, many variables must be considered first.
The younger you are and the lower your current income, the more likely this strategy will work because you can maximize the tax-free return potential of your Roth. If you’re a young worker, converting your 401(k) to a Roth portfolio can have huge benefits in the future.
“A Roth account needs time to grow and benefit from long-term tax savings. If you don’t have at least 10 years before you need to withdraw money from this account, it probably doesn’t matter. it makes sense to convert him,” says Cirksena.
This is also true if you currently earn less than you plan to withdraw in retirement. A Roth portfolio is actually a form of tax arbitrage. You pay taxes at your rates today in exchange for not paying taxes at your rates in retirement. The cost of this trade-off is that the tax money you pay today is all the capital you otherwise could have invested. This usually works in your favor if you pay lower rates today to save on higher rates later in life.
For example, let’s say you’re 30 years old and earning about $50,000 a year with the same amount saved in your 401(k). You pay an effective tax rate of 8.24%. Converting $12,500 per year would only increase your taxes from $4,811 to $6,011 per year, or about $6,000 in total conversion taxes. Since you’re likely to withdraw more income in retirement and pay higher taxes, it’s probably worth it.
On the other hand, let’s say you’re 67 with about $100,000 a year in retirement income and $1 million in your 401(k). If you took that money out as income over 10 years, you would pay $14,261 per year, or $142,610 in total. On the other hand, if you converted this portfolio 20% at a time, you would pay $57,786 in conversion taxes each year, for a total of $288,930.
At this stage of your life, you will pay twice as much in taxes to convert this portfolio as you would to live from it. But again, this is an overly simplistic example. A Financial Advisor can help you determine what the trade-offs might look like for you with this strategy.
That’s not to say there aren’t any circumstances where a mid-retirement conversion is worth it. This is especially true if you want to leave this money to your heirs, since a Roth IRA is a significantly more valuable inheritance than a 401(k). When it comes to managing your taxes and RMDs, whether you should convert to a pre-tax portfolio depends on your situation in life.
The essential
Is it wise to convert your 401(k) to a Roth IRA at 20% at a time? While this is a good way to manage the taxes of a Roth conversion, whether it makes sense overall depends a lot on your personal financial situation and how close you are to retirement.
Roth Conversion Tips
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