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Converting a 401(k) to a Roth IRA can be attractive for several reasons. Not only can you make qualified withdrawals from Roth accounts tax-free, but Roth accounts are also exempt from required minimum distributions (RMDs). That can give you more flexibility in withdrawing from your account in retirement and potentially save you money on taxes.
Imagine you’re nearing retirement age and have $1.3 million in a 401(k). If you convert the entire balance at once, you could incur a huge tax liability. On the other hand, gradually converting your 401(k) over a decade can reduce taxes compared to converting everything in one transaction.
Although you can convert $130,000 annually, you may want to change that amount later, especially depending on how the investments in your 401(k) are performing.
If you’re considering a Roth conversion or need help planning your RMDs, consider working with a financial advisor.
Required minimum distributions (RMDs) are required withdrawals from deferred retirement accounts, beginning at age 73.
RMD withdrawals you must take from tax-deferred retirement accounts beginning at age 73 (the RMD age increases to 75 for anyone who turns 74 after December 31, 2032). These withdrawals are treated as regular 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% per year for the next 14 years, your 401(k) could grow to more than $2.77 million. When you start taking RMDs after you turn 73, your first RMD will be more than $104,000. If you are a single filer and the only other taxable retirement income is $25,000 in Social Security benefits, that would increase your marginal tax rate from 12% to 24% (based on 2024 tax brackets).
Avoiding RMDs isn’t the only reason to consider a conversion. You can also switch if you think you will be in a higher tax bracket after retirement. Additionally, Roth accounts can make it easier to leave your assets to your heirs, so a conversion can be a useful estate planning tool. But if you need help deciding whether a Roth conversion is right for your situation and goals, reach out to a financial advisor and talk about it.
If you turn over €1.3 million in one go, you will end up in the highest marginal tax bracket – 37% – and you will have to pay more than €430,000 on your next tax return. Making a series of annual conversions of $130,000 over the next ten years could significantly reduce this tax bill.
For illustration purposes, assuming you have $60,000 in other taxable income each year, after deductions and credits, your annual income for the conversion period will be $190,000. As a sole filer, that puts you in the 24% bracket and you’ll have to pay about $35,000 a year in taxes (assuming you take the standard deduction). Over the ten-year conversion period, you would hypothetically pay more than $350,000 in taxes, but potentially save around $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 one year, you can convert a larger amount. The central idea is to convert just enough of your 401(k) savings to bring your taxable income to the next tax bracket threshold, but not above. If you’re interested in Roth conversions or other tax planning strategies, consider working with a financial advisor.
A couple nearing retirement is looking at their 401(k) balance and considering a Roth conversion.
Converting 401(k) funds to a Roth account can make financial sense, but there are some risks and limitations associated with this step. For starters, you must wait five years after setting up a Roth IRA before you can withdraw any investment earnings from the account. Breaking this rule could result in income taxes and possibly 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 complete a conversion before you can withdraw the converted funds. However, this specific five-year rule does not apply to people who are 59 ½ years of age or older.
If you set up your Roth now at age 59 and start withdrawing before age 64, you may have to pay taxes on some withdrawals.
Additionally, implementing a Roth conversion strategy requires making predictions about future tax rates and the returns your investments will generate. Forecasts involve risks, because events can turn out differently. For example, if you expect future tax rates to be lower and they will rise as current law requires, it might have been better to convert more now.
You may also wish you had converted more if your investments yield higher returns than expected. That could result in your 401(k) having more money than you expect when you complete your conversion plan, so you still have to take RMDs.
Finally, if you have any money left in your 401(k), don’t forget to take RMDs as required. If you do, you may owe a penalty of 25% of the amount you should have withdrawn as an RMD. And don’t forget, a financial advisor can help you plan for RMDs and their tax implications.
By rolling over money from a 401(k) or other tax-deferred retirement account, you can avoid RMDs and potentially reduce your tax liability. Gradually rolling over part of your 401(k) each year can make sense as a way to reduce your current tax bill. However, you may need to be flexible with the amount you convert if tax rates or your investment returns turn out differently than you planned.
If you have deferred retirement accounts, you’ll want to get an idea of ​​how much your RMDs might be and plan for their tax impact. Calculating your RMDs yourself is relatively easy, but SmartAsset has built an RMD calculator to make it even easier. The free tool helps you estimate how much your first RMD will cost and when it should be taken.
When deciding how to transfer money from a 401(k) to a Roth account, you should carefully evaluate your options. A financial advisor can help with this. Finding a financial advisor does not have to be difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory meeting with your advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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