Transferring some of your retirement savings from a tax-deferred account like a 401(k) to a Roth IRA can help you reduce or possibly avoid required minimum distributions (RMDs) and income taxes later on. It can also be beneficial if you want to leave tax-free savings to your heirs. A Roth conversion can therefore provide you with some flexibility when tax planning your finances in retirement.
However, you can’t escape paying income taxes on your tax-deferred savings entirely, and converting 25% of a large 401(k) could lead to a sizable tax bill you’ll have to pay right now. You may want to consider a conversion strategy based on keeping you from entering a higher marginal income tax bracket rather than converting a set percentage, although other timing factors may come into play.
Here are some factors to think about. You can also get matched with a financial advisor for free if you need help developing a 401(k) conversion plan that will balance present and future tax consequences.
Roth Conversion Rules
Because Roth accounts are not subject to the required minimum distribution (RMD) rules that apply to 401(k) accounts, a retirement saver may want to consider converting funds from a 401(k) to a Roth IRA. Under RMD rules, funds left in a 401(k) or similar tax-deferred account have to be withdrawn on a strict schedule starting at age 73 or 75, depending on your birth year.
Unlike Roth withdrawals, which are usually tax-free, 401(k) withdrawals are treated as taxable income. As a result, taxable RMDs can force a retiree into a higher income tax bracket and potentially pose a financial hardship in your golden years when you may be on a fixed income. By reducing or eliminating the need to take mandatory RMDs, a saver can look forward to the likelihood of paying fewer income taxes in retirement and having more to spend on lifestyle expenses.
Examples: Taxes Owed on Roth Conversion Strategies
The challenge of Roth conversion is that amounts transferred from a tax-deferred account to a Roth IRA are considered taxable income. In the case of a sizable conversion, this can bump a saver into a higher marginal income tax bracket and lead to a large tax bill that is due when filing the current year’s return.
For example, if your 401(k) is worth $1 million and you convert 25% in one year, or $250,000, that would add $250,000 in taxable income to your current income. If you are a single filer with no other income, this would put you in the 32% marginal tax bracket and lead to a tax bill of approximately $53,014, using the rates in effect for the 2024 tax year.
You may be able to manage the tax impact by spreading the conversion out over more years. For instance, if you are 63 now, you have 10 more years before your first RMD is due at 73. Converting 10% or $100,000 each year would put you in the 22% bracket for tax year 2024. Then you’d face an annual tax bill of about $13,841 if you had no other income.
A somewhat different strategy is to focus not on the percentage of your 401(k) you’ll convert each year. Instead, chiefly consider the impact the conversion will have on your tax bracket and current year tax bill. For instance, if you are a single filer with $110,000 of taxable income, you will be in the 24% bracket for 2024. In that situation, you can convert $81,950 before your taxable income reaches the threshold of $191,151, which would catapult you into the 32% tax bracket and make it so that any additional dollars converted come with a heftier tax bill.
A financial advisor can help you run the math in your situation. Use this free tool to match with up to three vetted fiduciary advisors.
Roth Conversion Refinements
Some people may want to consider the possible impact of the five-year rule on conversions. This regulation imposes a penalty on withdrawal of any earnings of converted funds if they are taken sooner than five years from the time the funds were converted. The five-year rule only applies to withdrawals taken by people who are under age 59 ½, however, so it may not affect you if you plan to start taking withdrawals after that time.
Another factor to keep in mind is your likely tax rate after retirement. If you will be in a lower tax rate after retirement, you may not want to do a Roth conversion now, as this might result in you paying more taxes over all. Still, some people might like the flexibility to avoid RMDs, or want to use a Roth IRA as a tax-free inheritance mechanism for their heirs if they expect to have money left over at the end of their lifetime. Consider weighing the pros and cons based on your goals with a financial advisor.
Bottom Line
Converting all or a significant part of a large 401(k) can result in a big current tax bill. Balanced against that is the prospect of avoiding RMDs. You may be able to better handle the tax impact of a conversion if you spread the conversion process out over several years, gradually converting a 401(k) to a Roth rather than doing it all at once. However, it’s likely more effective to base the amount you are converting on the immediate impact on your marginal tax bracket, rather than simply converting a set percentage every year. Converting just enough to bring you up to the top of your current tax bracket is one way to do this.
Tips
- Finding a financial advisor doesn’t have to be hard. 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.
- Your living expenses after retirement may have a larger financial impact than your tax liability, and SmartAsset’s Cost of Living Calculator can help you compare the cost of living in different locations so you make a savvy decision about where to retire.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
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