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 in retirement, a Roth conversion may make sense. That's because Roth accounts aren't subject to mandatory withdrawals that can increase taxable income in retirement. The main catch is that converting funds to a Roth requires paying taxes on converted funds at your ordinary income rate, which can result in a large tax bill in the short term. That's one reason gradual transitions can make sense, but there are many dynamics to consider.
If you're considering a Roth conversion, talk about it with a financial advisor to see if it fits with 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 which force withdrawal after reaching the age of 73 or 75, depending on your year of birth. Adding RMD income to your other retirement income can bump you into a higher tax bracket and increase your overall retirement tax bill.
However, Roth IRAs are not subject to these RMD rules. You can leave money in your Roth IRA account indefinitely, letting it grow tax-free and even pass it on tax-free to your heirs. This does convert money from a 401(k) to a Roth IRA is a potentially useful move for people looking to reduce taxes in retirement or as part of an estate plan.
Roth conversions are not for everyone, however. One reason is that converted funds are immediately taxed as current income. For this reason, gradual transitions is a popular refinement of the strategy. By rolling over a portion of the 401(k) funds each year, you spread the tax bill and could reduce the overall amount you pay in taxes.
Let's explore a few hypothetical scenarios.
A 58-year-old with $1.4 million from a 401(k) could convert $140,000 a year 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 conversion rate, assuming a 7% annual return on investments in the 401(k), it would take about 16 years to empty the account. The total tax bill could come to $797,024, assuming that income and conversion amounts do not change and that tax rates also remain the same. This compares to a one-time tax bill of $507,784 if the entire balance of $1.4 million were converted in one year. While this is generally lower, it doesn't account for the taxes that will be taken out of RMDs after you reach adulthood.
If no funds were converted, in the 17 years it would take for the saver to reach age 75 and become subject to RMDs, First year RMD it would be about $145,760, assuming an average annual return of 7%. 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 reduce your overall tax bill during your lifetime and retirement. For example, some may find it advantageous to vary your Roth conversion amounts each year to stay within a certain lower tax bracket.
A financial advisor It can help you project your tax burden for Roth conversion strategies.
A Roth conversion can affect several other components of your financial plan. For example, 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 extra income could also lead to higher premiums for Part B and Part D coverage.
It's generally best to use money from another source to pay the conversion tax, so you can maximize the money that can grow tax-free in the Roth account. If you have to use a portion of the converted fund to pay the taxes due, converting may make less sense.
The five year rule that restricting converted withdrawals without penalty may also be a concern for some savers. Because of this limitation, it may be most advantageous to only convert money that you will not need to cover living expenses within five years. For those over the age of 59.5, the five-year rule may not be a concern.
Given the long timeframes involved and the difficulty of accurately predicting future tax rates and income, making a Roth conversion plan necessarily involves some uncertainty. If assumptions about your post-retirement bracket are off, you could wind up paying more in taxes than if you hadn't carried out the conversion.
Consider using this free tool to match with a financial adviser who can help guide you through Roth conversions and other aspects of retirement planning.
A Roth conversion can help you manage your retirement tax liability and potentially 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'll be in a lower tax bracket in retirement. However, conversion means taking on a current tax liability, and this tax bill is better paid using money from another source.
Finding a financial advisor doesn't have to be difficult. 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, start now.
Retiring to a less expensive location can help balance your retirement budget. Use SmartAsset Cost of Living Calculator to compare how much it will cost to live in different cities.
Keep an emergency fund handy in case you run into unexpected expenses. An emergency fund should be liquid — in an account that is not at risk of significant fluctuation like the stock market. The trade-off is that the value of liquid money 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 adviser 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 AMP SmartAsset.
