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Roth conversions later in life can require some tricky math.
As you approach retirement, one of the most important questions is how to manage taxes on your retirement income. For households that rely on pre-tax portfolios like a 401(k) or a traditional IRA, this means anticipating ordinary income taxes on all your withdrawals. It also means anticipating necessary withdrawals associated with the IRS’s Required Minimum Distributions (RMD) rule.
As a result, it is common for people in their 60s to at least consider rolling their money into a Roth IRA. This can have significant benefits. It eliminates your taxes in retirement, along with your RMD requirements, and will even improve the after-tax value of your estate.
The problem is that as you approach retirement, a Roth conversion can become very expensive. You’ll pay quite a bit of conversion tax upfront in exchange for those long-term income tax savings.
To see this, let’s say you’re 62 and have $900,000 in your 401(k). In this case, will you save money by converting your portfolio to a $90,000 per year Roth IRA? Here are some things to think about. Also consider talking to a financial advisor for personalized guidance.
Any pre-tax retirement portfolio, including 401(k)s and traditional IRAs, has two major issues that households should be aware of.
First, these portfolios are taxed as ordinary income when you retire. This means you pay taxes at income tax rates, rather than the special lower rate usually reserved for investments and capital gains. These taxes apply to your entire withdrawal, not just the portfolio gains, since your original contributions were tax-deferred.
Second, all portfolios have pre-tax Required Minimum Distributions (“RMDs”). This is a minimum amount you must withdraw from any pre-tax retirement account you hold. Currently, required minimum distributions begin at age 73, which means you must begin taking these minimum withdrawals the year you turn 73. The exact amount you need to withdraw is based on a combination of the value of your portfolio and your age.
Required minimum distributions are a form of government tax planning. This is an IRS rule designed to ensure that you start triggering tax events on your pre-tax portfolios so that it can collect scheduled income, and the penalty for not collecting your full RMD will be calculated on your taxes.
The easiest way to avoid both taxes and RMDs is through a Roth IRA.
After-tax portfolios have no required minimum distributions. You do not pay tax on the money you withdraw from these accounts.
To take advantage of this, many households are considering a so-called Roth conversion. This is when you transfer money from a qualifying pre-tax portfolio, such as a 401(k) or an IRA, to an after-tax Roth IRA. You can exchange any amount of money as long as it comes from a valid pre-tax account. Once the money is transferred to a Roth IRA, it grows tax-free and you will have no income tax or RMD requirements in the future.
The catch with a Roth conversion is that you have to pay conversion taxes up front. When you convert money into a Roth portfolio, you include the entire converted amount as taxable income for the year in question. This will increase your taxes for the year proportionately.
Suppose you are an individual and earn €75,000 per year. Normally, you would owe about $8,761 in annual income taxes. However, let’s say you convert your $900,000 401(k) to a Roth IRA this year. This would bring your taxable income for the year to $975,000, and you would owe a total income tax of $315,958.
If you are over 59 1/2, you can withdraw money from your portfolio to pay these taxes. Here, for example, your Roth conversion could increase your taxes by an estimated $307,197 for the year. If you take that out of your portfolio, you’ll be left with $592,803 in your Roth IRA after taxes. If you are under age 59 1/2, or if you want to leave your money, you will need another source of money to pay these taxes.
A fiduciary financial advisor can help you navigate the Roth conversion rules and calculations based on your own circumstances and assumptions. Use this free tool to match.
As we illustrate above, conversion taxes can be a major drawback to a Roth conversion.
Specifically, the closer you are to retirement, the more likely it is that the cost of conversion taxes will exceed your future tax savings. Chances are you’ll move into a higher tax bracket later in your career, you’ll transfer more money as you approach retirement, and your Roth IRA will have less time for tax-free growth.
One way to help manage this is through something called staggered conversion. This is when you exchange smaller amounts of money in stages, rather than a large amount of money at once.
The main benefit of a staggered conversion is that it can keep your tax brackets low. The more money you convert, the higher your taxable income and the higher your resulting tax brackets. This means that you pay higher taxes per dollar converted than if you convert less at a time. By converting your money into smaller, spread out amounts, you can keep your tax brackets lower.
Take our example here. Converting all $900,000 at once pushes your taxable income into the 37% bracket, with an effective tax rate totaling 32.02% (not counting your ordinary income for the year). On the other hand, if you only turn over €90,000, that only falls into the 22% tax bracket and an effective rate of 13.40%.
Again, if you ignore your income, each $90,000 conversion would generate $12,061 in income taxes. This would amount to $120,610 over ten years, less than half of the $307,197 in conversion taxes you would pay if you made this move all at once.
So, should you exchange your money? It depends on your goals. As you approach retirement, you may spend more money on conversion taxes than you save on income taxes and RMD requirements. However, if you want to maximize the value of your estate, you usually preserve the most assets for your heirs by letting them inherit a tax-free Roth IRA.
To understand that, let’s look at your $900,000 401(k). For simplicity, we assume that both inflation and portfolio growth are ignored, although in practice neither are trivial concerns.
Let’s assume your income is the rough median of $75,000 per year. If you turn over $90,000 per year, this would bring your annual taxable income to $165,000. Your tax bracket would increase slightly from 22% to 24%, and you would pay conversion taxes of about $20,915 per year ($29,676 total taxes – $8,761 in income taxes against $75,000 in income).
Over ten years, this would amount to a total of $209,150 in conversion taxes, leaving you with $690,850 in a Roth IRA at age 72.
Let’s further assume that you use a standard 4% withdrawal strategy, which means you take 4% out of this portfolio every year for 25 years. With our Roth IRA after conversion, this would give you approximately $27,634 in after-tax income annually ($690,850 * 0.04). With your traditional IRA, you would have an estimated $33,652 in after-tax income each year ($900,000 * 0.04 = $36,000 – $2,438 in taxes).
So in this case, you could have more income by leaving your money in place, and that’s before we even take into account lost growth and opportunity costs due to the conversion taxes. However, these examples are simplified and do not take into account certain dynamics, such as portfolio growth, inflation, and your own income level and retirement needs. For customized help, consider speaking with a vetted fiduciary advisor.
There are many ways to look at it, but in most cases the result is the same. By the time you reach your 60s, your retirement accounts will have grown large enough to trigger very significant conversion taxes. At the same time, a new Roth portfolio will have little (if any) time to enjoy tax-free growth that would offset these taxes. The result is that it’s rare to save money on taxes through a late-career move, but it can be a huge boon for the right people.
A Roth IRA can certainly help you manage your taxes and RMD withdrawals in retirement by eliminating them altogether. However, when you retire, make sure your long-term savings actually exceed the upfront conversion tax, or you may end up paying a hefty premium for that convenience.
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Roth IRAs are a fantastic financial tool, but they are especially useful if you time them right. Perhaps more than any other retirement account, these will be most valuable to you early in life, when you can maximize the tax benefits.
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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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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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The post I’m 62 with $900,000 in my 401(k). Should I Convert $90,000 Per Year to Avoid Taxes and RMDs in Retirement? first appeared on SmartReads by SmartAsset.
