If I have a tax-deferred 401(k). Can I convert it to a Roth IRA without paying the taxes deferred if I roll it over?
-Tommy
In general, the answer here is no. There is usually no method to completely avoid taxes on a Roth conversion. Eventually, Uncle Sam will come to collect on your tax-deferred retirement accounts — either when you make a Roth conversion, withdraw money, or collect your required minimum distributions (RMDs).
That said, your inability to avoid taxes completely does not translate into an inability to reduce them. Here are some smart strategies to lower your tax bill on a Roth conversion. (Consider working with a financial advisor to learn more about taxes and retirement.)
Strategies to Reduce Your Tax Bill on a Roth Conversion
To reduce the tax consequences of rolling a tax-deferred account into a Roth, consider these methods:
Make a tax-conscious partial Roth conversion
One strategy to reduce the tax liability of a Roth conversion is to spread your rollovers over several years. To use this strategy, you convert just enough to bring your total income up to the limits of your current tax bracket without moving into the next tax bracket. (Consider working with a financial advisor to learn more about taxes and retirement.)
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Roll over your money in a low-tax year
For many people, a prime time for Roth conversions occurs in the years after retirement, but before Social Security and RMDs kick in. These may be relatively low-income years where initiating a conversion can result in a threefold benefit. Those benefits include: lower tax bills, lower RMDs, and future tax-free growth.
Speaking of timing, if you suspect tax rates will rise with the expected demise of the Tax Cuts and Jobs Act or due to political machinations on Capitol Hill, a Roth conversion may be an option now.
You maintain your current tax rate and hopefully benefit from any future increases. Keep in mind that no one has a crystal ball, and this strategy involves making predictions about the future. (For more information about how tax policy can impact retirement planning, consider working with a financial advisor.)
Pay taxes wisely
Many experts recommend paying the taxes on your Roth conversion with non-retirement assets. That’s as opposed to withholding some of your retirement money to pay the bill. This allows you to move the largest amount into your new Roth account and continue to watch it grow tax-free.
Work with a financial advisor
A financial advisor may be able to help you take a holistic look at your tax and retirement profile and identify opportunities to minimize taxes while adhering to an investment philosophy that suits your stage of life.
A good advisor can tell you whether a Roth conversion makes sense at this time. He or she can also discuss alternatives, such as converting your 401(k) to a traditional IRA, transferring to a new employer’s 401(k) or making a partial conversion.
Tips for dealing with taxes during your retirement
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Consider a few advisors before choosing one. It’s important to make sure you find someone you trust to manage your money. As you consider your options, these are the questions you should ask an advisor to ensure you make the right choice.
Susannah Snider, CFP® is SmartAsset’s financial planning columnist, answering reader questions on personal finance topics. Do you have a question that you would like answered? Email [email protected] and your question may be answered in a future column.
Please note that Susannah is not a participant in the SmartAdvisor Match platform and is an employee of SmartAsset.
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