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Legally, it’s never too late to make a Roth conversion. The IRS allows you to transfer eligible income at any time as long as you can pay the resulting tax bill.
For those in or near retirement, the big question is whether it’s a wise call to do a Roth conversion. On the other hand, a tax-free portfolio gives you more control over your money. On the other hand, you will have little chance to take advantage of the tax increase.
A financial advisor can help you build a retirement plan that takes into account taxes, cost of living, retirement accounts and more. Talk to a counselor today.
A Roth IRA is known as a “post-tax” retirement account. This is in contrast to traditional tax-deferred accounts, such as a traditional IRA or 401(k).
With a pre-tax portfolio, you receive a tax deduction for all eligible contributions as you make them during your working years. This makes it cheaper tax-wise to contribute to your retirement account, allowing you to invest more with the same amount of money. Then, upon retirement, you pay income tax on your withdrawals.
With a post-tax Roth IRA, you don’t receive a tax deduction for qualified contributions. This means that you are giving away money that you have already paid income tax on. This makes it more expensive to contribute to your retirement account in the short term, which effectively reduces the amount of money you can invest now. But then, in retirement, you don’t pay taxes on any withdrawals, including your earned income returns.
A Roth conversion is when you transfer assets from a pre-tax account to a post-tax Roth IRA. You can only transfer money from tax-deductible retirement accounts. Once you convert the money to a Roth IRA, it follows the basic Roth accounting rules and enjoys tax-free growth. However, you will need to be prepared to pay tax on that money, as it is being transferred to a deferred tax account. On the bright side, Roth IRAs do not require RMDs, which can be beneficial for retirees.
Unlike annual contributions, there is no limit on Roth conversion frequency or amount. You can change as much money as you want and as often as you choose.
The potential for tax-free growth makes a Roth IRA valuable, but it comes with a large up-front cost. Since this income is coming from a pre-tax portfolio, when you take a Roth conversion you must add the total amount converted to your taxable income for that year.
Using this example, say you hold $745,000 in a 401(k). If you convert this amount into a single currency, you will add $745,000 to your taxable income for that year and, as a result, you will owe state and federal taxes on the entire amount. While there are ways to work around this, usually by adjusting your conversion to stay within the lower tax bracket, there is no way to completely avoid paying income tax on the converted amount.
Depending on the amount in question, this can make a Roth conversion more expensive. As a result, for families considering conversion, the general rule of thumb is:
A Roth IRA is especially valuable early in life, when you have more time to enjoy its tax-free growth. It is especially important if you now pay a lower tax than you will pay on withdrawal, as that allows you to pay a lower rate now in exchange for avoiding a higher rate in the future.
A pre-tax portfolio is especially important if you now pay higher taxes than you will pay in retirement, as the tax-deferred account allows you to save on your current higher rate in exchange for paying a lower tax rate in the future.
If you need help building a retirement financial plan, consider speaking with a financial advisor today.
There are many ways to manage your 401(k) in retirement, and converting the portfolio to an IRA is one common way. In this case, you can choose to transfer your 401(k) to a traditional IRA or Roth IRA.
However, all Roth IRA contributions are subject to a cooling-off period. So if you contribute money to a Roth IRA in or near retirement, be sure to plan not to be able to access that money for five years. If you withdraw before that, you will be subject to a 10% early withdrawal penalty.
According to Tim Maurer, Chief Advisory Officer at wealth management firm SignatureFD, turning around in retirement can sometimes be a good idea.
“[E]Approaching retirement can be one of the best times to consider a Roth conversion, when taxable income drops in line with those of high-income earners later in a person’s career and may also be lower than later in retirement when RMDs force retirees to take. the money is taxed,” he said.
But, Maurer said, don’t make changes for the sake of it. You need to have a goal and a strategy to justify important up-front costs. Beyond “tax arbitrage,” which is taking advantage of lower rates now compared to higher rates later, Maurer offers three main reasons a retiree might want to consider switching their income.
You don’t have to take RMDs with a Roth IRA, which can increase the benefits of increasing interest growth.
Tax diversification is important in retirement, especially for large purchases. If you want to pay for something like a new car or a big trip, instead of risking a higher tax rate by withdrawing extra money from a pre-tax account you can dip into a tax-free Roth IRA.
Maurer also says, “there may not be a better gift that an heir can receive than a Roth IRA.” While the pre-tax retirement account balance leaves the tax return to your heirs, the Roth IRA leaves it a pure, tax-free asset.
The question, he said, is how important each of these issues is to you. It is important that each house chooses itself.
You can save more on a Roth conversion by staggering your conversion, which, given the five-year rule, can still be beneficial. Given this low Social Security retirement income, they would have more room for lower tax returns each year.
However, even accounting for the reduced tax rate of a Roth IRA, this household does not stand to receive much immediate benefit from converting their income. Unless their tax situation changes significantly in retirement, or if they have other assets, it is unlikely that they will see a significant tax return on their conversion costs. A Roth IRA can work if, as Maurer says, they are looking for tax diversification or a solid estate plan. But it’s important to make that plan before moving any money.
Consider talking to a financial advisor who can help you navigate the nuances of a Roth conversion in your case.
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with three financial advisors serving your area, and you can have a free initial call with your advisor match to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
A Roth IRA is typically portfolio-managed, meaning you have to choose and balance your investments. While everyone’s needs are different, here are a few places to start.
Keep an emergency fund available for unexpected expenses. An emergency fund should be liquid — in an account that isn’t as vulnerable to big swings as the stock market. The tradeoff is that the financial value of water can be reduced by inflation. But the high-interest account allows you to earn more interest. Compare savings accounts from these banks.
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The post I’m 66, Taking Social Security, and I Have $745,000 in a 401(k). Is It Too Late to Convert to a Roth IRA? first published on SmartReads and SmartAsset.
