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Should You Convert Your Traditional 401(k) or IRA into a Roth 401(k) or IRA?

November 28, 2022

Taxes can significantly affect your retirement plan and leave you with much less money than you thought you would have. Fortunately, you can take steps to reduce taxes, including considering whether to convert your traditional 401(k) or IRA into a Roth 401(k) or Roth IRA. This option is not right for everyone, which is why you should consult financial and legal advisors to discuss your situation. However, here are some of the key points to understand. 

What Is a Roth 401(k) or IRA?

A Roth 401(k) or Roth IRA is a type of Individual Retirement Account. It is similar to a traditional 401(k) or IRA in that the gains are not taxed while the account continues to grow. However, a traditional 401(k) or IRA tax your gains when you take out the money. With a Roth 401(k) or Roth IRA, you can withdraw your contributions and earnings tax and penalty-free after age 59½ provided the account has been open for five years. There is also no annual required minimum distribution (RMD) for a Roth 401(k) or Roth IRA as there is with a traditional IRA. This different treatment is explained by the fact that traditional 401(k) and IRA accounts are funded with pre-tax dollars, whereas Roth 401(k)s and Roth IRAs are funded with after-tax dollars. 

There is an income cap for Roth IRAs, so you may not be eligible to establish this type of account and make direct contributions to it depending on your income. However, taxpayers who are not eligible to contribute directly to a Roth retirement account may still be able to convert a traditional retirement account to a Roth account and reap the benefits that Roth accounts provide.

When Do You Pay Taxes on Your Retirement Account?

Many people hold a significant amount of their retirement savings in tax-deferred (but not tax-exempt) accounts. Traditional IRAs and 401(k)s funded with pre-tax dollars are tax-deferred accounts. Money withdrawn from those accounts will be treated as ordinary taxable income (at the highest rate) unless they are deemed qualified charitable distributions. 

Plan participants are also required to start withdrawing their RMD once they reach a certain age. Currently, the age is 72 years old for the original participant and/or a spouse or other dependent beneficiary. Non-spouse beneficiaries generally have to withdraw all of the funds within 10 years if the original participant died in 2021 or after. Once you start taking out money, you have to pay taxes in most cases.

As discussed above, Roth 401(k)s and Roth IRAs are different in that you don’t pay taxes on your gains when you withdraw funds. They are tax-exempt. Accordingly, some individuals want to convert their existing traditional IRA or 401(k) account into a Roth 401(k) or Roth IRA. While you may be able to do that if the applicable retirement plan rules allow for it, there are tax consequences to consider. You will have to pay taxes on the amount converted from your existing account at the time you convert it into a Roth 401(k) or Roth IRA. 

When Should You Convert Your IRA or 401(k) into a Roth IRA or Roth 401(k)?

The first step is to consider your current ordinary income tax rate compared to the one you will fall into when you expect to take money out of your traditional IRA or 401(k). If you think that you will have a higher tax bracket when you retire than you have now, then it may make sense to convert your existing account into a Roth IRA. Another important consideration is the amount of time between the conversion and when you expect to withdraw funds, and the average rate of return you expect the portfolio to yield during that time. As a general rule, the longer the time period the more likely the conversion will make financial sense. Keep in mind that you will take an immediate tax hit on the amount converted during the year, but you will save money later because your future earnings will not be taxed. Whether the conversion is worthwhile depends on your particular circumstances, the assumptions you make, and your risk tolerance.

How Can You Reduce Taxes in a Roth Conversion?

You may be able to time your conversion to reduce your tax bill. For example, you can convert your accounts in a year where your income is lower due to a lost job or higher than usual deductions that put you in a lower tax bracket. If the market is down, your accounts may also be worth less so you’ll also pay fewer taxes when you convert. 

However, you must always consider how you will pay the tax. You don’t want to use the money you are converting to pay your tax bill because that will further deplete your account. You should have other funds available to pay taxes.

Is a Roth Conversion Right For You?

It’s best to consult an attorney with experience in tax planning to help you evaluate your entire financial picture before making any decisions. Our firm works with individuals and business owners to develop comprehensive financial and estate plans customized to their situations and goals. Contact us for a consultation.

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