SmartAsset and Yahoo Finance LLC may earn commission or revenue through links in the content below.
Transferring funds from a 401(k) to a Roth IRA can help a retirement saver control the timing and, potentially, the amount of their future tax liability. In general, if your applicable income tax rate is likely to be higher after retirement, a Roth conversion can make sense. That’s because Roth accounts aren’t subject to mandatory withdrawals that can increase taxable income in retirement. The major catch is that converting funds to a Roth requires paying taxes on converted funds at your normal income rate, which can lead to a large tax bill in the short-term. That’s one reason gradual conversions can make sense, but there are a lot of dynamics to consider.
If you’re considering a Roth conversion, talk it over with a financial advisor to see if it fits your overall financial plan.
Tax-deferred retirement accounts such as those offered by 401(k) plans are powerful tools for funding a secure retirement. However, withdrawals are taxable as ordinary income. And these accounts are subject to Required Minimum Distribution (RMD) rules that mandate taking withdrawals after reaching age 73 or 75, depending on your birth year. Adding RMD income to your other retirement income can bump you into a higher tax bracket and increase your overall retirement tax bill.
Roth IRAs, however, are not subject to these RMD rules. You can leave money in your Roth IRA account indefinitely, letting it grow tax-free and even passing it tax-free down to your heirs. This makes converting funds from a 401(k) to a Roth IRA a potentially helpful move for people who want to minimize taxes in retirement or as part of an estate plan.
Roth conversions aren’t for everyone, however. One reason is that converted funds are taxed immediately as current income. For this reason, gradual conversions are a popular refinement of the strategy. By converting a portion of the 401(k) funds each year, you spread out the tax bill and may reduce the overall amount you’ll pay in taxes.
Let’s examine a few hypothetical scenarios.
A 58-year-old with a $1.4 million 401(k) could convert $140,000 per year as a way to help manage the tax bill. Assuming the saver has $100,000 in taxable income from other sources, the resulting $240,000 in total taxable income would put them in the 32% bracket and result in an annual tax bill of $49,814.
At that rate of conversion, assuming a 7% annual return on investments in the 401(k), it would take approximately 16 years to empty the account. The total tax bill could come to $797,024, assuming income and conversion amounts didn’t change and tax rates also stay the same. This compares to a one-time tax bill of $507,784 if the entire $1.4 million balance were converted in a single year. While this is lower overall, it doesn’t account for the taxes that’ll be taken out of RMDs once you come of age.
If no funds were converted, in the 17 years it would take for the saver to reach age 75 and becomes subject to RMDs, the first-year RMD would be approximately $145,760, assuming a 7% average annual return. If the saver still had $100,000 in additional income from other sources, using the 2024 tax tables, the retiree would have to face the same tax bill of $49,814. Depending on your goals, there are strategic ways to shrink your overall tax bill across your lifetime and retirement. For example, staggering your Roth conversion amounts each year to stay within a certain lower tax bracket may be advantageous for some.
A financial advisor can help you project your tax burden for Roth conversion strategies.
A Roth conversion can affect a number of other components of your financial plan. For instance, the converted amounts will be taxable income, which could increase tax on your Social Security benefits. Once you reach age 65 and become eligible for Medicare, the added income could also lead to higher premiums for Part B and Part D coverage.
Generally speaking, it’s best to use funds from another source to pay the conversion tax, so you can maximize the amount of funds that can grow tax-free in the Roth account. If you will have to use a portion of the converted fund to pay the taxes due, conversion may make less sense.
The five-year rule that restricts penalty-free withdrawals of converted funds may also be a concern for some savers. Because of this restriction, it’s may most advantageous to convert only funds that you won’t need to pay living expenses within five years. For those over age 59.5, the five-year rule may not be a concern.
Given the long time frames involved and the difficulty of accurately forecasting future tax rates and income, making a Roth conversion plan necessarily involves some uncertainty. If assumptions about your post-retirement bracket turn out to be off, you could wind up paying more in taxes than if you had not performed the conversion.
Consider using this free tool to match with a financial advisor who can help guide you through Roth conversions and other aspects of retirement planning.
A Roth conversion can help you manage your retirement tax obligation and possibly reduce the overall tax bill. That’s because Roth accounts aren’t subject to RMDs, and future withdrawals are tax-free. A conversion can make sense, especially if you will be in a lower tax bracket after retirement. However, a conversion means taking on a current tax liability, and it’s best to pay this tax bill using funds from another source.
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.
Retiring to a less expensive location can help balance your retirement budget. Use SmartAsset’s Cost of Living Calculator to compare how much it will cost to live in different cities.
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.
