By converting your 401(k) to a Roth portfolio, you can avoid RMDs entirely. This is a legitimate form of tax planning. However, often there is a difference between whether you can do something and whether you should do something; whether it is allowed and whether it is in your best interest in the long run.
For example, suppose you are 62 years old. You have $1.6 million in a 401(k). If you convert this portfolio to a Roth IRA at 10% at a time, you can avoid required minimum distributions on your $1.6 million. However, especially for households nearing retirement, a Roth conversion can result in a net loss. There is a chance that the tax costs of these conversions will outweigh the tax benefits of avoiding minimum distributions.
Here are some things to consider. Also consider matching with a fiduciary financial advisor who can help you weigh your options.
What are RMDs?
Beginning at age 73 (or 75 starting in 2023), the IRS requires you to make regular minimum withdrawals from any pre-tax retirement account. This includes 401(k) and traditional IRA portfolios. These withdrawals are known as RMDs.
The exact amount you need to bring is based on the total value of the portfolio on January 1 and your age. You have until the end of each year to complete the withdrawal. So you can take your minimum distribution in any amount at any time on or before December 31. If you don’t take your minimum distribution, the IRS will charge a tax penalty normally worth 25% of the untaken amount.
As with all withdrawals, you must pay ordinary income taxes on your minimum distributions. This can be a problem if you need less money than your minimum benefit, such as if you have other sources of income or multiple retirement accounts. In that case, you might prefer to leave the money aside for tax-free growth, rather than paying income tax on an unnecessary distribution.
One solution to this is to convert your pre-tax portfolio to an after-tax Roth account, because the IRS does not require minimum distributions on Roth IRAs.
How do Roth conversions work?
A Roth conversion is when you move money from a pre-tax retirement account, such as a 401(k), to an after-tax Roth IRA.
Mechanically, the process is usually simple. You open a Roth IRA with a qualified brokerage. You can then instruct your plan administrator to transfer your pre-tax portfolio assets to the Roth IRA, or you can personally withdraw the money and assets and deposit them into the new account. If you move the money personally, you have 60 days to deposit it into the Roth portfolio.
There is no limit on how much money you can exchange each year, nor is there a limit on how often you can do it. But the tax implications may make you think twice about how much you make in a given year.
A financial advisor can help you weigh the tradeoffs to determine whether a Roth conversion is the right strategy to maximize your retirement income. Make a match with a financial advisor today.
Tax implications
You must pay income tax on the entire amount you convert. Any amount of money you convert into a Roth IRA counts toward your taxable income for that year. For example, if you convert $160,000 from your 401(k) to a Roth IRA, you add that $160,000 to your taxable income for the year. If you’re under age 59 1/2, you’ll need the cash to pay the tax bill. If you are older, you can take the tax money out of your retirement account. In all cases, this will reduce your potential savings and investment capital.
Once you make a Roth conversion, these assets continue to grow tax-free. For qualified retirement distributions, you also don’t pay taxes at all on this money if you withdraw it later in life, and it doesn’t count toward your total taxable income.
A staggered Roth conversion is often effective at reducing the overall impact of conversion taxes because you can manipulate your withdrawals to avoid moving into higher tax brackets to some extent. Take our example here. Set aside other sources of income for the year and say you want to convert $1.6 million from a 401(k) to a Roth IRA. You can do this in one year in one lump sum, or via transfers of €160,000 over a ten-year period (without taking into account portfolio growth over that period). In this hypothetical case, your income taxes would be approximately:
Lump sum transfer:
Spread transfer:
By converting your money in stages, less of it is exposed to the highest tax brackets, reducing your overall payments.
If you’re making staggered conversions near your retirement age, keep this in mind: When you convert money to a Roth IRA, the five-year rule applies. In the case of conversions, this means you will have to wait five years before you can make a qualified withdrawal of converted amounts unless you are over age 59 1/2.
Portfolio growth, inflation and your other income can affect your actual tax liability. Consider matching with a financial advisor who can help you make more accurate calculations for your goals.
It comes down to
By converting your 401(k) to a Roth IRA, you can completely avoid having to take RMDs and pay taxes on them. However, this will lead to upfront conversion taxes. The closer you are to retirement, the more likely it is that these conversion taxes will overshadow any benefits.
Tips for managing your RMDs
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Whether you want to maximize portfolio growth, have multiple income streams, or leave assets for your heirs, minimizing RMDs is often an important part of retirement planning. Here are six strategies that can help you make this happen.
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A financial advisor can help you draw up a comprehensive retirement plan. 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.
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Keep 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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The post I’m 62 with $1.6 million in my 401(k). Should I Convert $160,000 Per Year to a Roth IRA to Avoid RMDs? first appeared on SmartReads by SmartAsset.
