Transferring funds from a 401(k) into a Roth IRA lets you make tax-free free withdrawals in retirement, avoids rules on mandatory distributions and adds flexibility for estate planning. However, when converting a large amount of money, the potential tax bill becomes a major issue. Fortunately, strategies exist that can reduce the tax bill significantly and they are well worth considering. On a conversion like this, you could save hundreds of thousands of dollars. If you are thinking of converting funds in a 401(k) into a Roth IRA, talk it over with a financial advisor.
How Roth Conversion Works
You can convert funds into an after-tax Roth from pre-tax savings vehicles including 401(k), 403(b), and 457 plans as well as traditional IRAs, SEP IRAs and Simple IRAs. To start the process, contact the bank or other custodian of the pre-tax account and let them know what you plan to do. They’ll facilitate the conversion. Make sure the conversion is completed within 60 days, or you could owe a 10% early withdrawal penalty. Otherwise, it’s straightforward.
Roth conversion offers attractive benefits, including the ability to make tax-free withdrawals in retirement. Withdrawals from pre-tax accounts like a 401(k), by contrast, are taxed as ordinary income. You’ll also be free of Required Minimum Distribution rules and, if you leave a Roth account to your heirs, they may be able to enjoy tax-free distributions over their entire lives.
One potential negative to Roth conversion is that it is a one-way process. Once you convert funds from pre-tax status to after-tax status, you can’t go back. But the biggest drawback is that any funds you convert are added to your income for the year you convert them. It can still make sense to if you expect to be in a higher tax bracket in retirement. However, especially when converting a large amount, it can result in an eye-watering tax bill right now.
For example, if you are a single filer who converts a $920,000 401(k) into a Roth IRA in a single transaction, for 2024 this would put you in the highest 37% tax bracket. Without any additional income, deductions or other adjustments, your tax bill that year just on the conversion would be $298,588.
Talk to a fiduciary financial planner about the tax implications of making a Roth conversion.
Conversion Tax Reduction Strategies
There is no way to completely avoid taxes on a Roth conversion. However, there are several ways you may be able to convert your 401(k) to a Roth IRA without owing quite so much in taxes. Keep in mind, these are oversimplified examples to demonstrate the concept of these strategies. You can get matched with a financial advisor for free to discuss your personal situation.
- Partial conversion. If you stretch the conversion over several years instead of doing it all at once, you can manage and potentially reduce the amount you will owe in taxes. For instance, if a single filer split the conversion into four equal $230,000 transactions, you would likely avoid being bumped into the highest tax bracket. Assuming you have no other income, you’ll be in the 32% bracket and the annual tax bill would be $51,287, equal to $205,148 over four years for a nearly $25,000 tax savings over the single-year method. One common approach is to convert just enough each year to bring total taxable income up to the top of the current or next bracket.
- Timed conversion. If you expect your income to be lower during certain years it may make sense to convert more during those years. For example, say you normally have $60,000 in taxable income after taking the standard deduction. If you convert $230,000, you’ll owe about $80,000 in federal taxes on $290,000 in income from earnings and conversion. If you take a year off of income-producing work to travel or volunteer, you could double the amount you convert that year. If you’re married filing jointly, this strategy would take advantage of your income changes to avoid a higher tax bracket.
- Pay taxes using after-tax funds. One way to pay taxes on a Roth conversion is to take it out of the converted funds. However, this will cost you, since these funds won’t be able to grow tax-free. If you can pay taxes with after-tax funds from savings or selling other investments, converted funds will continue to grow and be available to withdraw later free of taxes.
Ultimately, there are tradeoffs to every financial decision. Consider speaking with a financial advisor to weigh your options.
Bottom Line
You can’t escape taxes on a Roth conversion entirely, but you may be able to reduce the taxes you’ll owe. The simplest approach, converting the entire 401(k) to a Roth in a single year, will generate a large tax bill next time you file a return. You may be able to significantly lower this amount by doing partial conversions and concentrating conversions in low-income years. Using after-tax funds to pay any taxes due can cut your long-term tax bill.
Tips
- Any time you are considering a major financial move such as converting a large retirement account, it is a good idea ask a financial advisor about your options. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Make sure your emergency fund isn’t losing out to inflation. It’s best to keep your liquid assets in a high-yield savings account or CD.
- If you are going to be subject to RMDs, you can use SmartAsset’s RMD Calculator to tell you how much you’ll have to take out each year.
Photo credit: ©iStock.com/skynesher