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Many savers with large tax-deferred accounts such as 401(k)s are interested in converting those funds to Roth accounts to avoid paying required minimum distributions (RMDs) and related taxes in retirement. This isn’t always the right move, partly because of the high upfront fees for conversions. But in the right situation, it can be a serious financial move. For example, a saver who expects to have a higher tax bracket in retirement may be better off paying conversion taxes now at the lower current rate. Consider weighing the pros and cons of converting your retirement account with the help of a financial advisor familiar with the details of these transactions.
RMDs are required distributions that retirement savers in tax-deferred accounts must start taking out of their accounts at age 73, whether they need the money to pay for expenses or not. These withdrawals are fully taxed, meaning retirees may end up paying more income tax than they’d like and, in the worst case scenario, move into a higher tax bracket.
Transferring funds from a 401(k) or other tax-deferred account to a Roth account on an after-tax basis allows retirement savers to plan for the future without RMDs because Roth accounts are not subject to RMD rules. In addition, Roth withdrawals are tax-free after retirement, further reducing the tax burden on retirees.
The downside of a Roth conversion is the current tax bill. Converting $75,000 of 401(k) funds to a Roth increases the saver’s income by $75,000 that year. Assuming the saver is single and has a household income of $75,000, this will move them from the 22% marginal income tax bracket to the 24% bracket. Their federal income tax bill will increase from about $8,800 to $26,000.
Another potential problem with conversion is that the rules prohibit tax-free withdrawals of converted contributions for five years. In most cases, the five-year rule means they may have to pay taxes on Roth withdrawals unless they delay retirement for five years after converting.
While converting will avoid RMDs, it may not reduce your overall tax burden compared to not converting. For example, a pensioner may be in a lower tax bracket after retirement. If this happens, you can save money by leaving the money in a tax-deferred account and paying taxes on withdrawals in retirement. A financial advisor can help you weigh the tax bill tradeoffs in your situation.
It’s important to remember that conversions cannot be undone. This is strictly a one-way process, so the saver is advised to make sure it is the right thing to do before making the conversion.
Gradually converting your 401(k) funds to a Roth can help you manage and potentially lower your overall tax bill. For example, converting all $750,000 in one year could put a taxpayer in the top 37% tax bracket based on their income. This would generate an estimated tax bill of $232,708 for the converted amount.
Converting $75,000 a year would spread that fee over at least a few years. However, converting at this rate is unlikely to deplete the 401(k) because the funds in the tax-deferred account will continue to grow as the conversion process gradually moves them into the Roth account. For example, assuming deferred investments earn a 7% average annual return, 13 years until RMDs begin at age 73, converting $75,000 annually would leave approximately $180,738 in the account.
Converting larger amounts would increase your annual tax bill, while converting smaller amounts would leave even more funds in a tax-deferred account where they would be subject to RMDs. But that might not be a bad thing. It often makes sense to have funds in both tax-deferred and after-tax accounts for retirement to allow flexibility in tax planning. If you have questions about the best retirement strategy, consider using this free tool to match with a financial advisor.
Transferring tax-deferred retirement funds to an after-tax Roth account can be an effective way to reduce or avoid RMDs. However, this is far from a free move. It can be difficult to balance costs and profits in order to make the optimal decision on how and whether to proceed with the conversion. Key concerns include your projected retirement age and expected tax bracket at retirement.
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Consider meeting with a financial advisor to discuss plans for converting funds from a tax-deferred account to a Roth account. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool will match you with up to three financial advisors in your area, and you can survey your advisors for free to decide which one 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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With SmartAsset’s federal income tax calculator, you can find out how much you’ll owe next tax day.
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Have an emergency fund in case of 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. However, a high-interest account allows you to earn compound interest. Compare the savings accounts of these banks.
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