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Roth conversions at the end of life can require some tricky math.
As you approach retirement, one of the most important questions will be how to handle taxes on your retirement income. For households that rely on pre-tax portfolios like a 401(k) or traditional IRA, this means anticipating ordinary income taxes on all your withdrawals. It also means anticipating the required withdrawals associated with the IRS’s Required Minimum Distributions (RMD) rule.
As a result, it’s common for people in their 60s to at least consider converting their money into a Roth IRA. This can have significant advantages. It will eliminate your taxes in retirement, along with your RMD requirements, and even improve the after-tax value of your wealth.
The problem is, as you get closer to retirement, a Roth conversion can become very expensive. You’ll pay quite a bit of conversion fees upfront in exchange for those long-term income tax savings.
To see this, let’s say you’re 62 years old and have $900,000 in your 401(k). In that case, will you save money by converting your portfolio to a $90,000 per year Roth IRA? Here are some things to think about. You should also consider speaking with a financial advisor for personalized guidance.
Every pre-tax retirement portfolio, including 401(k)s and traditional IRAs, has two major issues that households should keep in mind.
First, these portfolios are taxed as ordinary income when you take withdrawals in retirement. This means you pay tax at income tax rates, rather than the lower special rate normally reserved for investments and capital gains. These taxes apply to the entire withdrawal, not just the portfolio earnings, because your initial contributions were tax-deferred.
Second, all pre-tax portfolios have what are called Required Minimum Distributions (“RMDs”). This is a minimum amount you must withdraw from each pre-tax retirement account you own. Currently, required minimum distributions begin at age 73, meaning you must start taking these minimum withdrawals the year you turn 73. The exact amount you need to withdraw is based on a combination of your portfolio value and your age.
Mandatory minimum distributions are a form of tax planning by the government. This is an IRS rule designed to ensure that you start triggering tax events in your pre-tax portfolios so they can collect planned income, and the penalty for not taking the full RMD is assessed on taxes.
The easiest way to avoid both taxes and RMDs is through a Roth IRA.
After-tax portfolios have no required minimum distributions. This is because you don’t pay any tax on the money you withdraw from these accounts.
To take advantage of this, many households consider what’s called a Roth conversion. This is when you transfer money from an eligible pre-tax portfolio, such as a 401(k) or IRA, into an after-tax Roth IRA. You can convert any amount of money you want, provided it comes from a valid pre-tax account. Once the money has been moved into a Roth IRA, it will grow tax-free and you will have no income tax or RMD requirements in the future.
The problem with a Roth conversion is that you have to pay conversion fees up front. When you convert money into a Roth portfolio, you include the entire converted amount as taxable income for that year. This increases your taxes for the year proportionately.
For example, let’s say you’re a person who earns $75,000 a year. Typically, you would owe around $8,761 in annual income taxes. However, say you convert your $900,000 401(k) to a Roth IRA this year. This will bring your taxable income to $975,000 for the year and you will owe total income taxes of $315,958.
If you are older than 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 about $307,197 for the year. If you take that out of your portfolio, you’ll have $592,803 left in your Roth IRA after taxes. If you are under 59 1/2 or want to leave your money in place, you will need to have another source of funds to pay these taxes.
A trusted 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 fees can be a big downside to a Roth conversion.
Specifically, the closer you are to retirement, the more likely it is that the costs of conversion fees will exceed future tax savings. You may be in a higher tax bracket later in your career, you’ll roll over more money as you get closer to retirement, and your Roth IRA will have less time for tax-free growth.
One way to help manage this is through what is called a staggered conversion. This is when you convert smaller amounts of money in stages rather than a large amount of money all at once.
The key advantage of a phased conversion is that it can help keep tax rates low. The more money you convert, the higher your taxable income and the higher your resulting tax rate. This means you’ll pay higher fees for each dollar converted than you would if you converted less at a time. By converting your money into smaller, staggered amounts, you can keep your tax brackets lower.
Take our example here. If you convert all $900,000 at once, you’ll push your taxable income up to 37%, with an effective tax rate of 32.02% overall (leaving out your regular income for the year). On the other hand, if you only convert $90,000, that would only fall into the 22% tax bracket and an effective rate of 13.40%.
Again, excluding income, each $90,000 conversion would generate $12,061 in income taxes. That would come to $120,610 over 10 years, less than half the $307,197 in conversion fees you’d pay if you made the move all at once.
So should you convert your money? It depends on your goals. If you’re nearing retirement, you may spend more money on conversion fees than you’ll save on income taxes and RMD requirements. However, if you want to maximize the value of your estate, you will typically preserve the largest asset for your heirs by allowing them to inherit a Roth IRA tax-free.
To understand this, let’s look at the $900,000 401(k). For ease of use, we will assume both inflation and portfolio growth, although in real life these are not trivial concerns.
Let’s say your income is about the median of $75,000 per year. If you convert $90,000 a year, that would push 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 in total taxes – $8,761 in income taxes on $75,000 in income).
Over 10 years, that would total $209,150 in conversion fees, 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 the post-conversion Roth IRA, this will give you about $27,634 in after-tax income each year ($690,850 * 0.04). With the traditional IRA, you would have an estimated after-tax income of $33,652 each year ($900,000 * 0.04 = $36,000 – $2,438 after taxes).
So in this case, you might get more revenue by leaving the money, and that’s before we factor in lost growth and opportunity costs due to conversion fees. However, these examples are simplified and do not account for certain dynamics such as portfolio growth, inflation, and your own income level and retirement needs. For personalized help, consider speaking with a verified fiduciary advisor.
There are many ways to look at it, but in most cases the result is the same. By age 60, retirement accounts have grown large enough to generate very significant conversion fees. At the same time, a new Roth portfolio will have little (if any) time to enjoy tax-free growth that would offset those fees. The upshot is that it’s rare to save money on taxes by doing a late-career conversion, but it can be a big plus for the right people.
A Roth IRA can definitely help you manage your taxes and RMD withdrawals in retirement by eliminating them altogether. However, as you get closer to retirement, make sure your long-term savings will actually outweigh the initial conversion fees, or you could be paying a hefty premium for that ease.
Roth IRAs are a fantastic financial vehicle, but they’re especially useful if you time them well. Perhaps more than any other retirement account, these will be most valuable to you early in life, when you can maximize your tax advantages.
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. The free SmartAsset tool matches you with up to three verified financial advisors serving your area, and you can have a free introductory call with your matched 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.
Keep an emergency fund handy in case you face unexpected expenses. An emergency fund should be liquid – in an account that is not exposed to significant fluctuations, such as the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But a high interest account allows you to earn compound interest. Compare savings accounts from these banks.
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