I’m a Financial Advisor: Why It’s Wise To Convert 10% of Your 401(k) Into a Roth IRA Each Year

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Rolling over a traditional 401(k) plan into a Roth IRA could be a smart financial move with long-term tax benefits — that is, in certain situations, according to the AARP.

Indeed, as AARP explained: “A traditional 401(k) is funded with pretax dollars, so when you take withdrawals, you have to pay taxes on your contributions and earnings at your regular income tax rate. On the other hand, contributions to Roth IRAs are made with after-tax dollars, which means all future withdrawals are tax-free.”

“So the goal of converting a traditional 401(k) into a Roth IRA is to keep any future gains tax-free, and to keep any future withdrawals tax-free, too,” according to the AARP. “But there’s a catch. You will have to pay taxes at your personal income tax rate on any traditional 401(k) assets you roll over to the Roth IRA at the time of the conversion, according to IRS [Internal Revenue Service] rules.”

Required Minimum Distributions (RMDs)

RMDs are the minimum amounts you must withdraw from your retirement accounts each year. You generally must start taking withdrawals from your 401(k) plans, 403(b) plans, and 457(b) plans, according to the IRS. In addition, the RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.

On the other hand, Roth IRAs do not require withdrawals until after the death of the owner, according to the IRS.

“That means Roth accounts give your money more time to compound in a tax-deferred account,” Anthony Ogorek, president and founder of Ogorek Wealth Management, told the AARP.

In addition, Kevin Ross — senior managing director, Bridgeway Wealth Partners — explained that if you successfully migrate your 401(k) assets over to a Roth IRA by moving over 10% per year (doing it slowly generally avoids a big tax bill) you don’t have to worry about RMDs since Roth IRAs do not have RMD requirements.

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“At Bridgeway Wealth Partners, we love this strategy and generally encourage our clients to do this,” he said. “Considering that U.S. deficit spending is not abating, we believe it’s just a matter of time before tax rates return to the high levels they were at in the 1970s. As a result, we believe it’s wise to convert 10% of your 401(k) to a Roth IRA per year until your 401(k) assets have been fully migrated into a Roth IRA which is far more favorable in a future high-tax environment.”

Tax Rates Set To Increase Moving Forward

As Fidelity explained, one reason to consider a Roth conversion this year is that tax rates are set to rise in the future with the sunsetting of the 2017 Tax Cuts and Jobs Act, which expires at the end of 2025.

“That could mean some big changes in tax rates, unless there are other revisions to tax law. The top bracket could revert to 39.6% from 37%, and some of the lower brackets could increase by as much as 4 percentage points,” according to Fidelity.

Ross explained that if someone defers into a 401(k) while they are in a 35% tax bracket and then withdraws money years later — when they are in a 50% tax bracket — they made the wrong choice and would have been substantially better off had they converted 10% of their 401(k) balance each year.

“Over 10 years, the 401(k) will have been fully converted to a Roth IRA and future withdrawals from a Roth IRA are tax-free. Keep in mind that even Roth distributions, while tax-free, still count as income, meaning that they contribute to your AGI [adjusted gross income],” he said.

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Therefore, if you have $100,000 of tax-free Roth IRA income, all of your other taxable income starts at $100,001.

“In other words, the IRS will wallop you on all of your other taxable income. But you will still be light years better off than if you did nothing and your 401(k) was taxed at a much higher rate,” he concluded.

When Should You Convert?

There are a lot of factors to consider before rolling over some of your 401(k) into a Roth IRA — namely tax liability, how close you are from retiring and your income.

According to Wells Fargo, generally, a Roth IRA conversion makes sense if:

  • You won’t need the converted funds for at least five years.
  • You expect to be in the same or a higher tax bracket during retirement.
  • You can pay the conversion taxes without using the retirement funds themselves.
  • You live in a state with no income tax but will retire to a state that has income tax.
  • And/or you may not need the funds for retirement and may want to transfer them to your beneficiaries.

On the other hand, Wells Fargo explained that a Roth IRA conversion may not be the right fit for you if:

  • You are not sure what your tax situation will be like this year.
  • You have to deplete other assets to pay the taxes due on the conversion.
  • You are pushed into a higher tax bracket due to the amount you convert.
  • You will be in a lower tax bracket in retirement.
  • And/or you will be relocating to a state with no or lower state income tax.

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