SmartAsset and Yahoo Finance LLC may earn commission or revenue through links in the content below.
Converting a 401(k) to a Roth IRA can be exciting for a number of reasons. Not only can you make qualified withdrawals from the Roth account tax-free, but the Roth account is also exempt from required minimum distributions (RMDs.) That can give you more flexibility when withdrawing from the account in retirement and potentially save money on taxes.
Imagine you are approaching retirement age and have $1.3 million in your 401(k). Converting the entire balance in one swoop can leave you with a massive tax liability. On the other hand, converting your 401(k) gradually over a decade can reduce taxes compared to converting all in one transaction.
While you can start converting $130,000 a year, you may want to change that amount later depending on how your investments in your 401(k) are doing.
If you’re thinking about a Roth conversion or need help planning RMDs, consider working with a financial advisor.
Required minimum distributions (RMDs) are mandatory withdrawals taken from tax-deferred retirement accounts, beginning at age 73.
Your RMD withdrawals must be taken from a tax-deferred retirement account starting at age 73 (the RMD age increases to 75 for anyone turning 74 after December 31, 2032). These withdrawals are treated as ordinary taxable income, so RMDs can push you into a higher tax bracket and increase your tax bill.
For example, if you have $1.3 million in your 401(k) at age 59 and earn 4% annually for the next 14 years, your 401(k) could grow to more than $2.77 million.. When you start taking RMDs after turning 73, your first RMD will be over $104,000. If you are a single filer whose only taxable retirement income is $25,000 in Social Security benefits, that will increase your marginal tax rate from 12% to 24% (using the 2024 tax bracket).
Avoiding RMDs isn’t the only reason to consider conversion. You may want to convert if you think you’ll be in a higher tax bracket after you retire. Also, Roth accounts can make bequeathing wealth to beneficiaries easier, so conversions can be a useful estate planning tool. But if you need help determining whether a Roth conversion is right for your situation and goals, connect with a financial advisor and talk about it.
If you convert $1.3 million in one lump sum, this will put you in the highest marginal tax bracket – 37% – and require you to pay more than $430,000 on your next tax return. Creating a series of $130,000 annual conversions over the next 10 years could significantly reduce this tax bill.
Assuming for illustration purposes that each year you have $60,000 in other taxable income after deductions and credits, your annual income during the conversion period would be $190,000. As a single filer, that would put you in the 24% bracket and require you to pay about $35,000 a year in taxes (assuming you take the standard deduction). Over the 10-year conversion period, you’ll pay more than $350,000 in taxes but potentially save about $80,000 compared to a lump-sum conversion.
In some situations, you can use other conversion strategies. For example, if you expect a lower income a year, you can convert a larger amount. The main idea is to convert enough of your 401(k) savings to bring your taxable income up to the next tax bracket threshold — but not past it. If you’re interested in Roth conversions or other tax planning strategies, consider working with a financial advisor.
A couple who are nearing retirement are looking through their 401(k) balances and considering doing a Roth conversion.
Converting your 401(k) funds into a Roth account can make financial sense, but there are some risks and limitations to this move. To begin with, you must wait five years after establishing a Roth IRA to withdraw investment earnings from the account. Violating this rule can trigger income tax and potentially a 10% early withdrawal penalty.
There is also a separate five-year waiting period that applies specifically to Roth conversions. The IRS requires you to wait five years from the beginning of the year in which you completed the conversion before you can withdraw the converted money. However, this particular five-year rule does not apply to people who are 59 ½ or older.
If you set up a Roth now at age 59 and start taking withdrawals before you’re 64, you may have to pay taxes on some withdrawals.
Also, implementing a Roth conversion strategy should make predictions about future tax rates and returns on your investment. Forecasts involve risk because events may vary. For example, if you expect future tax rates to be lower and higher, as current law expects, you may be better off making more changes now.
You may want to convert more if your investment returns higher than expected. This could result in your 401(k) having more money than you expected when you complete the conversion plan, so you still have to take RMDs.
Finally, if you have money left in your 401(k), don’t ignore RMDs as a mandate. If you do, you could owe 25% of the amount you have to withdraw as RMDs. And remember, a financial advisor can help you plan your RMDs and their tax implications.
Converting funds from a 401(k) or other tax-deferred retirement account can help you avoid RMDs and potentially reduce your tax liability. Gradually turning over a portion of your 401(k) each year can be a way to reduce your current tax bill. However, you may need to be flexible about the amount converted if your tax rate or investment returns are different than planned.
If you have a tax-deferred retirement account, you’ll want to know your RMD amount and plan for the tax impact. Calculating your own RMD is easy enough, but SmartAsset built an RMD calculator to make it even easier. A free tool can help you estimate how much your first RMD will cost and when to take it.
Deciding how to move funds from a 401(k) to a Roth account requires carefully evaluating your options. A financial advisor can help. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three designated financial advisors serving your area, and you can have a free introductory call with your advisor 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, start now.
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 fluctuations like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But high interest accounts allow 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 converting. Learn more about SmartAsset AMP.
Your Trusted Source for Accurate and Timely Updates!
Our commitment to accuracy, impartiality, and delivering breaking news as it happens has earned us the trust of a vast audience. Stay ahead with real-time updates on the latest events, trends.
