Is it Wise to Convert 10% of My 401(k) into a Roth IRA Each Year to Avoid Taxes and RMDs?

Is it Wise to Convert 10% of My 401(k) into a Roth IRA Each Year to Avoid Taxes and RMDs?

A Roth IRA has a couple of significant advantages. Most notably, they allow your retirement savings to grow tax-free (as opposed to tax-deferred) and they have no required minimum distributions (RMDs). If your priority is to control your retirement savings, then a Roth IRA might be the right choice.

However, Roth IRAs have their disadvantages too, including when you roll over assets. You receive no deduction for contributions or conversions, paying full income taxes on that money. That tax spending is all capital that you could have otherwise invested, creating a significant up-front cost and potential opportunity cost.

For example, say that you have a 401(k) and are considering converting 10% of it each year into your Roth IRA. Will this help you effectively avoid taxes and RMDs? Is it wise overall? Let’s look at each of these questions in turn.

If you need help planning your retirement tax strategy, talk to a fiduciary financial advisor for free.

What Is A Roth Conversion?

A Roth conversion is when you move assets from a qualifying pre-tax account, like a 401(k), into a Roth IRA. Once you make a conversion, those assets follow the rules of a post-tax account. They grow tax-free, you pay no taxes on withdrawals, and you have no RMDs.

However, a Roth conversion does come with an up-front bill. When you move money into a Roth account you must pay income taxes on the full value of the conversion. In practice, this means you add the value of the conversion to your taxable income for that year.

For example, say you convert $100,000 worth of stocks from your 401(k) to your Roth IRA. Those investments will now grow tax-free, with no taxes when you withdraw the money later in life. You would add $100,000 to your AGI for that year, and would need the cash on hand to pay the resulting income tax increase.

Nuances: Age Restrictions and the Five-Year Rule

There is no limit to how much you can convert, although in practice it’s limited by the value of your pre-tax accounts. Nor is there any limit on how often you can convert funds. Individuals over 59 1/2 can use the converted assets to pay those taxes with no penalty, reducing the value of the portfolio in the process. Anyone younger should have another source of cash to pay those taxes. However, any assets that you convert must remain in place for at least five years before you withdraw either principal or returns. This makes a Roth conversion difficult for individuals approaching retirement. If you have questions about how the rules work, you can get matched with a financial advisor.

But Will It Help You Avoid Taxes?

So, let’s say that you have a 401(k), and are thinking about converting 10% of it each year for the next 10 years. Will it help you avoid taxes?

Yes and no. You won’t avoid taxes, but this can be an effective way to manage them.

Yes, converting your money to a Roth IRA will eliminate taxes on withdrawals. In retirement, you won’t have to worry about paying taxes on this money at all. Doing this will also eliminate taxes for your heirs, if you leave this portfolio to your estate. They, too, can cash out this account tax-free.

But no, converting your money to a Roth IRA will not let you avoid taxes. It will restructure your taxes. Instead of paying in retirement, you will pay those taxes up front. Each year, when you convert 10% of your 401(k), you will pay income taxes on that money in that year’s filing. Depending on your AGI, it is possible to structure your conversion so that you stay in lower tax brackets, however.

Talk to a financial advisor about the best way to reduce your taxes in retirement.

Will It Help You Avoid RMDs?

Yes, converting your entire 401(k) will allow you to avoid RMDs.

A required minimum distribution, or RMD, is a rule that applies to pre-tax retirement accounts. Starting at age 73, each year you must withdraw a minimum amount of money from each pre-tax portfolio that you own. The exact amount depends on the portfolio’s value and your age.

For example, say that you are 73 with $1 million in your 401(k). The IRS will require you to withdraw at least $37,735 from this account by the end of the year or pay a significant tax penalty.

The purpose of an RMD is to trigger income taxes. Since you haven’t yet paid taxes on a pre-tax account, the IRS wants you to pay something eventually. In our example above, say, you would owe at least $2,648 in taxes on this minimum withdrawal.

A Roth IRA is entirely exempt from this rule because you have already paid taxes on this money. Since Roth withdrawals do not trigger a tax event, the IRS do not require them. So converting your 401(k) to a Roth IRA will certainly let you avoid RMDs on that money.

Is It Wise?

This is the bigger question. Converting your 401(k) to a Roth IRA will let you restructure your taxes, but not avoid them and will eliminate RMDs entirely.

Is it a wise move though?

That depends entirely on your personal situation and goals.

As a threshold matter, staggering this conversion is generally a good idea. Moving your 401(k) 10% at a time will help keep each year’s income in a lower bracket, so that you pay high rates on as little of this income as possible.

For example, say that you make $110,000 per year and have $1 million in your 401(k). You are currently in the 24% tax bracket. You could convert up to $81,950 (the upper AGI limit of the 24% tax bracket of $191,950, minus $110,000 W2 income) this year without triggering a higher tax rate.

A financial advisor can help you do the math for your situation.

So if you want to do this, staggered conversions are probably the right way. The bigger question is whether this is a good idea at all. That’s a conversation for your financial advisor. Are you close to retirement, for example? If so, a Roth conversion might not offer many benefits to offset the tax payments and five-year lock. On the other hand, are you relatively early in your career? If so, a Roth conversion might let you pay your current, lower, tax rate to save on your (hopefully) higher tax rates later in life.

Or, is your priority to eliminate RMDs? If your number one goal is to ensure that you can decide when and how to manage this money, then a Roth conversion will certainly accomplish that.

The question is just whether that’s the right move for you.

The Bottom Line

Is it wise to convert your 401(k) to a Roth IRA? The answer will depend entirely on your personal needs and financial situation. But if you need control over your finances, more than anything else, a Roth conversion can certainly get you there.

Roth Conversion Tips

  • We’ve talked about this in theory, but let’s take a look at all of this in practice. Say that you’re sitting on a $1.4 million IRA and have recently started retirement. Should you start rolling that money over to a Roth account? 

  • Don’t let your emergency fund or other cash reserves lose purchasing power to inflation. Make sure your money is earning competitive interest rates.

  • A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/Bill Oxford

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