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There is no age limit for Roth conversions, so you can transfer your pre-tax savings to a Roth IRA regardless of your age or retirement status. As long as you have qualifying funds in a pre-tax portfolio, you can move them into an after-tax Roth account.
That does not mean that a conversion is always wise. For retired households, the benefits of a Roth conversion are often relatively small compared to the costs of this switch. For example, say you’re 65, taking Social Security benefits and have $830,000 in your 401(k). Technically, you are completely free to do a Roth conversion. In practice, however, it may not provide as much financial benefit as you might expect.
A financial advisor can help you make important decisions about your retirement accounts, such as whether you should make a Roth conversion. Contact a fiduciary advisor today.
A retiree is considering converting her 401(k) to a Roth IRA.
A Roth conversion refers to the process of transferring money from a qualified pre-tax retirement account, such as a 401(k) or traditional IRA, to a Roth IRA. There’s an important caveat: the transfer requires you to pay income tax on the money you convert.
When you contribute to a pre-tax account, such as your 401(k), you receive a full tax deduction for the amount invested. You then pay income tax on all withdrawals (both returns and principal) at retirement. But when you contribute to a Roth IRA, you don’t get a tax benefit on the amount invested. In return, qualified withdrawals can be made completely tax-free. Roth accounts are also not subject to required minimum distributions (RMDs) because the money has already been taxed.
The main benefit of a Roth IRA is that your portfolio grows completely tax-free. If you invest €1,000 and it grows to €10,000, you only pay tax on the €1,000 before it reaches your account. A pre-tax portfolio, on the other hand, gives you more capital to invest in the first place. Every dollar you don’t pay taxes on is a dollar that can grow over time.
Consider talking to a financial advisor if you need help managing your retirement savings or are deciding between a pre-tax account and a Roth account.
When you make a Roth conversion, each dollar converted is added to your taxable income for that year. For people under 59.5, you need another source of liquidity to pay those taxes. However, if you are age 59 ½ or older, you can pay these taxes with money from your wallet. Keep in mind that this will reduce the value of your portfolio and its long-term growth potential.
For example, let’s say you convert $830,000 from your 401(k) into a Roth IRA. Also imagine that your income corresponds to the average American household income of about $75,000. A lump sum conversion would increase your marginal tax rate from 22% to 37%, potentially causing you to pay hundreds of thousands in federal taxes. On the other hand, you’ll never pay taxes on that money again, giving you access to tax-free returns and withdrawals later in life.
Finally, all Roth conversions have a five-year cooling-off period. This means that you must leave the money and the associated returns for five years after the transfer. Fortunately, a financial advisor can be a valuable resource if you need help completing a Roth conversion or navigating the tax rules of Roth IRAs.
A retiree enjoys a cup of coffee after doing some work on her finances.
Late-stage Roth conversions are a common question. People often ask if they can transfer their retirement funds to a Roth account. That’s the wrong question. The real issue is: should they?
The rule of thumb is that a Roth portfolio is most useful if your current tax rate is lower than the expected tax rate in retirement. It’s also particularly useful if your portfolio has more time to grow so you can maximize the value of those tax-free returns.
In contrast, a pre-tax portfolio may be a better option if you currently pay higher taxes than you will in retirement. This allows you to defer your current (higher) taxes until later in life, when you pay a lower rate.
In our example, suppose you are 65 and have already started collecting Social Security. If you’re not yet fully retired, you probably will be soon. Performing a conversion requires you to spend a lot of tax money upfront, which significantly reduces the long-term growth potential of your portfolio.
For example, suppose you spread your conversion over five years (converting $136,084 each year) to reduce the conversion to a lump sum. Let’s assume you receive a blended return of 8% during that period. Here’s how it could end:
Without Roth conversion
401(k) value at 70: $1.23 million
Portfolio income at 70 (using the 4% rule): $49,500
With annual Roth conversions
Roth value at 70: $800,000
Portfolio income at 70 (using the 4% rule): $32,000
This example doesn’t take into account the growth of your 401(k) during that five-year conversion, meaning you would have to make additional conversions to completely clear the account before taxes. It also does not take into account the taxes that would be due on the pre-portfolio withdrawals. However, this example illustrates how Roth conversions at this stage of life have the potential to significantly reduce your after-tax income in retirement.
Of course, there are some cases where a Roth conversion can be helpful later in life. Most notably, if managing RMDs is your biggest concern, you can accomplish that with a Roth conversion. You can pass a Roth IRA tax-free to your heirs and use the portfolio as a source of short-term spending money without affecting your overall taxable income. But if you want to explore the possibility of a Roth conversion or other aspects of your retirement income plan, consider talking to a financial advisor.
You’re never too old to legally complete a Roth conversion. You can do this at any time, as long as you have eligible funds in a pre-tax retirement account. But the closer you are to retirement, the more likely a Roth conversion will lose some of its luster.
Roth conversions may not always make sense, but that doesn’t mean they’re out of place. Converting a traditional IRA or 401(k) to a Roth IRA can pay off in tax savings and significant tax-free growth over time. The challenge is to figure out what makes the most sense for you. Many people simply look at their current tax rate and compare it to their projected tax rate in retirement to determine whether or not they should make a Roth conversion. But Vanguard, the financial services company, found that an investor’s individual “break-even tax rate” (BETR) can provide a better indication of whether a Roth conversion will be worthwhile.
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.
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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The post I’m 65, take Social Security and have $830,000 in a 401(k). Is it too late to convert to a Roth IRA? first appeared on SmartReads by SmartAsset.
