I’ve been warming up to the idea of converting part of my 401k to a Roth for some time. The gist of the tax maneuver is to pay the taxes upfront on the conversion, and then the money that’s converted will be forever tax-free. There are several benefits of a converted Roth IRA for a younger investor like myself, especially if I’m not using any retirement account money to pay for the tax bill. Still, I want to make sure I cross all the “T”s and dot all the “I”s before I make the conversion.
Here’s a checklist I came up with for anyone thinking of converting as well.
Figure out ahead of time where taxes for the conversion will come from. Will you be paying for the tax bill out of your conversion, or will you be using outside funds? If you are planning to pay the taxes out of money inside your retirement account, then it’ll be pretty much a wash if your tax rate stays the same on the year of your conversion versus when you take out the money if you didn’t convert.
If however, you are paying for the tax payment with outside funds, then it could make sense even if you believe your marginal tax rate would be lower when you withdraw. That’s because paying for the tax bill when you convert with outside funds is similar to being able to contribute some of that outside funds into a Roth IRA.
Let me use an example to illustrate.
Let’s say you convert $100,000 in pre-tax money into a Roth IRA and your marginal tax rate is 30% when you combine state and federal taxes. You decide to pay for the tax cost of converting with your outside savings, so you use $30,000 to pay the tax bill.
Assuming 8% growth, your $100,000 of converted Roth IRA funds will become $466,096 in twenty years.
If no amount was converted, then you will have the same $466,096 in a pre-tax retirement account after two decades but now you have to pay taxes on any amount you take out from that pot. Assuming the same 30% tax rate, your after-tax benefit is $326,267.
Of course, the $30,000 outside savings you didn’t use to pay Uncle Sam will also grow. Ignoring the taxes paid along the way, that amount will become $139,829. You’ll notice that this amount added to $326,267 is precisely $466,096. At first glance, it seems like a wash. But that $30,000 of outside savings would have been subject to twenty years of taxes on the dividends that it paid out. Plus, the amount it’s grown to will now be subject to long term gains tax if you withdraw any of it.
The growth rate and length of time the amount has been converted magnifies the difference. In other words, the more compounding interest grows your converted amount, the more it favors paying taxes with outside money.
Timing of the conversion matters. Markets generally go up and that means you would want to convert as soon as you commit because the earlier you have money in the Roth, the more time it’s growing tax-free and the less money you’ll need to convert. Note though that you don’t have to pay taxes on the conversion until April of next year when your tax returns are due. Someone converting in January has roughly 15 months to come up with the tax payment. On the other hand, a person converting in December has about four months. Keep that in mind.
Funds you convert to a Roth IRA should remain in the account for five years unless you want to pay a penalty to take it out. You paid taxes on your conversion already, so money within a Roth isn’t subject to taxes. However, any amount you convert must remain in the Roth for at least five years. If you want to withdraw any amount within the Roth that you converted within five years, then there will be a 10% penalty assessed on the money that you took out.
Required Minimum Distributions (RMD) cannot be converted to Roth. Anyone 70 and a half are required to take what’s known as an RMD. This is a minimum amount of money that must be withdrawn from any pre-tax retirement account to be taxed by Uncle Sam. If you’d like to make a conversion and you are required to take RMD, then that money has to be taken out first and taxes paid before you can convert any additional amount to a Roth.
Converting to the same brokerage could be easier. If your pre-tax account and your Roth account is in the same brokerage firm, then it’s simply a matter of clicking a few buttons and typing in the amount you want to convert. It’s really easy to do and takes about a minute.
However, converting to a different brokerage may give you free money. Many brokerage firms are offering cash bonuses for new money that’s coming into their firm. When you convert, you might as well check to see if the amount you are considering qualifies for the bonus. The awesome news is that any bonus you qualify for will be deposited into your Roth account, so that amount will get to grow tax-free as well. The amount doesn’t count as contributions either, so you are still welcome to contribute more to it up to the yearly maximum for that tax year.
There are no more do-overs though, so make doubly sure you are committed to paying taxes for it now. You used to be able to make a conversion, then change your mind by re-characterizing your conversion back into pre-tax money if you decided that the conversion was a mistake. But the 2017 Tax Cuts and Jobs Act eliminated that juicy rule. That’s because people were abusing the loophole. What some people would do is convert a bunch of investments, and only keep the conversion on the investment that’s gained the most and re-characterize the rest.
Let me use another example to illustrate how people were taking advantage. Most people convert money into a Roth and be done with it without regard to which investments are being converted because you can always change the investments around after the conversion.
But let’s say I’m invested in a US index fund, an international index fund, a bond fund, and a commodities fund. I want to convert $25,000, but instead of converting $25,000 into one Roth account, I open four accounts. I then put $25,000 of pre-tax retirement funds in each of these four accounts with one of the four separate funds. I then allow these four funds totaling $100,000 to grow in those four Roth IRAs. After the year, my account balances came out to be $30,000, $28,000, $25,500, and $24,000 due to different performances from the underlying assets for the year.
I then keep the account with $30,000 but re-characterize the rest back into the pre-tax account because it’s better for me to have more money in a Roth. I still pay taxes on a $25,000 conversion, but the result is having more money in a Roth.
This loophole is closed now. It does mean that the rest of us won’t be able to use the rule as it was originally intended, which was a fail-safe just in case we change our mind.
I live in California and it’s possible that I could lower the tax hit on my retirement fund withdraws by a sizable amount if I just move after I retire. That’s a major reason why I haven’t converted any amounts I’ve saved in pre-tax money to Roth IRAs yet. Still, I’m starting to see that it’s possible a conversion will benefit me in the long run if I just bite the bullet and convert now even if I decide to move later.
I haven’t decided quite yet, but converting is definitely on my radar. Have you converted any amount to a Roth IRA? What made you decide to take the plunge?
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Another reason to do Roth conversions is to minimize RMDs in the future. If you have a lot in 401ks, your RMDs can push you into higher tax brackets when added to your social security benefits and other income. So by converting over time, you can pay for the conversion in a lower tax bracket. For example, going from the 12 to 22% bracket almost doubles your taxes.
Good point. Forced withdrawals (which is what RMD really is) gives you less flexibility to optimize your tax rates in the future. The lower you can make RMD, the more potential you will be better off financially.