While everyone is different from a tax bracket perspective, at what tax bracket does it make sense to convert your 401(k) to a Roth 401(k) and prepay the taxes? For example, I am 42 years old and have a combined income of $560,000 between myself and my wife, which puts us in the 35% federal tax bracket.
Combined, we have $2.6 million in retirement savings ($2.5 million of which is in traditional 401(k)/403(b) accounts). Assuming we both retire at age 67, does it make sense to convert the $2.5 million into Roth accounts and absorb the tax burden over the next five to ten years, compared to in 25 years from now?
– Gary
You are right when you say that everyone’s tax situation is different. Therefore, we can’t draw a line at a specific tax bracket and say, “This is the point at which Roth conversions make sense!” However, we can say that Roth conversions make sense if you are currently in a lower bracket than you expect to be in retirement. Let me show you some points to consider as you think about whether you are in that situation or not. This will help you determine the tax bracket at which Roth conversions make sense for you.
If you need help with retirement planning, tax strategy, or any other part of your finances, consider speaking to a financial advisor.
Tax brackets play an important role in whether you should convert deferred retirement savings into a Roth account.
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Because the analysis focuses on comparing your current and future tax rates. You are currently in a high bracket based on current tax laws. In itself, this suggests that Roth conversions are less likely to make sense for you, but that’s not the whole story.
Fortunately, determining your current tax bracket is quite simple, as it is usually a known value at any given time. For example, here you know that your marginal federal bracket is 35%.
There are times when this may not be so simple, such as if your income varies significantly from year to year. If that’s the situation, I usually recommend waiting until later in the year to do your analysis. There’s simply less guesswork involved in calculating your income in November than in January, so your estimate for the year will be more accurate.
As you point out, it’s also important to consider your income tax rate if it applies to you.
This part is a little trickier and less certain, especially if you’re still decades away from retirement. You must assess your future bracket against the backdrop of the uncertainty inherent in multi-decade planning. Your career, income, and tax laws may change over time. You can’t be sure how your investments will perform (and therefore how big your retirement nest egg might become). However, with reasonable assumptions, your analysis can still be useful.
One option is to think about the income you would want when you retire today. Then simply consider the tax bracket your income would place you in based on current tax law. If that tax rate is higher than your current rate, a conversion makes more sense. Conversions make less sense if that percentage is lower.
(Keep in mind that if you need help analyzing your tax situation and making plans for the future, you may want to consider contacting a financial advisor to talk about it.)
As you go through the process, there are some specific points to keep in mind:
Tax laws may change. As of today, the Tax Cuts and Jobs Act takes effect. However, the intention is for the relevant parts to disappear in 2025. The tax brackets and the standard deduction will return to pre-2018 levels (adjusted for inflation). Congress could also pass new laws that will change everything in the next 25 years. An unfortunate reality is that you have to make an assumption about what you think future tax rates will be.
Are you planning to move in retirement? Some states have no income tax. If you plan to retire, consider that state’s income tax rate when estimating your future rate.
Not all income is taxed in the same way. When you retire, keep in mind that Social Security receives preferential tax treatment and that, at most, only 85% of your benefits are included in your taxable income.
Annual deadline. Unlike contributions, which you can usually make before the tax filing deadline, Roth conversions must be completed by December 31 to file for a given year.
Focus on your marginal tax rate. Your marginal tax rate, rather than your effective rate, is the relevant rate to consider. That’s the tax bracket your next taxable dollar will fall into.
(And if you need more help making informed decisions based on these considerations, consider working with a financial advisor.)
A couple in their early 40s is reviewing their retirement accounts and considering a series of Roth conversions.
In addition to the potential tax benefits of a Roth conversion, Roth accounts give you more control and flexibility in retirement.
For example, because Roth withdrawals are not taxable, they do not affect the taxes on your Social Security benefits or Medicare IRMAA benefits. Additionally, there are no required minimum distributions (RMDs) associated with Roth accounts, meaning you don’t have to start withdrawing at a certain age. RMDs add to your taxable income and can potentially push you into a higher marginal tax bracket.
Finally, Roth accounts offer estate planning benefits because they pass on to heirs tax-free.
Depending on how important these considerations are to you, they may influence your analysis somewhat. In other words, if you’re currently in a 35% tax bracket, but estimate you’ll be in the 32% tax bracket in retirement, it’s worth considering whether that extra control and flexibility is worth the 3%. For some people the trade-off will be worth it, but for others it won’t. (If you need help finding financial advice, this free tool can help you connect with up to three financial advisors in your area.)
To determine whether Roth conversions make sense for you (and at which tax bracket they will have the most impact), start by identifying your current tax rate. Then estimate your future rate based on the assumptions you are comfortable with and compare it to what you are currently paying. Roth conversions make the most sense if your current marginal tax rate is lower than what you expect in retirement.
Converting assets during a market downturn is one way to reduce your tax liability with a Roth conversion, since the taxable amount is based on the value of the asset at the time of conversion. When the market recovers, the gains in the Roth account become tax-free, maximizing the benefits of the conversion.
A financial advisor can help you assess whether a Roth conversion is right for you, as well as when and how to make the conversion. 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 isn’t 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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