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There are no age restrictions on Roth conversions, so you can roll your pre-tax savings into a Roth IRA regardless of your age or retirement status. As long as you have qualified funds in your pre-tax portfolio, you can transfer them to an after-tax Roth account.
This doesn’t mean it’s always wise to switch. For retirement families, the benefits of a Roth conversion tend to be relatively small compared to the costs of such a conversion. For example, let’s say you are 65 years old, receiving Social Security, and have $830,000 in your 401(k) account. Technically, you are completely free to do a Roth conversion. But in practice, it may not bring as many economic benefits as you expect.
A financial advisor can help you make important decisions about your retirement accounts, such as whether to make a Roth conversion. Contact a fiduciary advisor today.
A Roth conversion is the process of moving funds from a qualified pre-tax retirement account (such as a 401(k) or traditional IRA) to a Roth IRA. There’s an important caveat: Transfers require you to pay income taxes on the funds you exchange.
When you contribute to a pre-tax account, such as a 401(k), you receive a tax deduction for the full amount invested. Then, in retirement, you’ll pay income taxes on all withdrawals (returns and principal). However, when you contribute to a Roth IRA, you do not receive any tax benefits on the amount invested. In return, qualified withdrawals are fully tax-free. Roth accounts are also not subject to required minimum distributions (RMDs) because the money is already taxed.
The main advantage of a Roth IRA is that your portfolio grows completely tax-free. If you invest $1,000 and it grows to $10,000, you only pay taxes on the $1,000 before it enters your account. On the other hand, with a pre-tax portfolio, you have more capital to invest in the first place. Every dollar you don’t pay taxes on is money that can grow over time.
If you need help managing your retirement savings or deciding between pre-tax and Roth accounts, consider speaking with a financial advisor.
When you make a Roth conversion, every dollar converted is added to your taxable income for the year. For those under age 59.5, you will need another source of liquidity to pay these taxes. However, if you are 59 ½ years old or older, you can pay these taxes with funds in your portfolio. Keep in mind that this can reduce the value of your portfolio and its potential for long-term growth.
For example, let’s say you convert $830,000 in your 401(k) to a Roth IRA. Also imagine that your income matches the U.S. median household income (approximately $75,000). A one-time conversion would raise your marginal tax rate from 22% to 37% and leave you with potentially hundreds of thousands in federal taxes. On the other hand, you will never pay taxes on the money again, allowing you to claim and withdraw tax-free later in life.
Finally, all Roth conversions have a five-year cool-down period. This means you must keep the funds and associated returns for five years after transferring them. Fortunately, a financial advisor can be a valuable resource if you need help making a Roth conversion or understanding the tax rules for a Roth IRA.
Late Roth conversions are a common problem. People often ask if they can transfer their retirement funds to a Roth account. This is the wrong question. The real question is, should they?
The rule of thumb is that a Roth portfolio is most useful when your current tax rate is lower than your expected tax rate in retirement. It’s also most useful when your portfolio has more time to grow, so you can maximize the value of those tax-free returns.
By contrast, if you pay more in taxes now than you will in retirement, a pre-tax portfolio may be a better choice. This allows you to defer your current (higher) taxes until a later time when you pay a lower tax rate.
In our example, let’s say you are 65 years old and have started receiving Social Security benefits. If you’re not fully retired yet, you probably will be soon. To convert, you have to spend a lot of tax money up front, significantly reducing your portfolio’s long-term growth potential.
For example, suppose you stagger your conversions five years ($136,084 per year) to reduce one-time conversions. Let’s say you earned an 8% return on your mixed assets during this period. The result is as follows:
No Roth conversion
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401(k) value is 70: US$1.23 million
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Portfolio return is 70 (Using 4% rule): $49,500
Annual Roth Conversion
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Roth value is 70: 800,000 US dollars
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Portfolio return is 70 (Using 4% rule): $32,000
Now, this example doesn’t take into account the growth of your 401(k) over the five-year conversion period, which means you’d have to make additional conversions to completely empty the pre-tax account. It also doesn’t take into account taxes owed on pre-portfolio withdrawals. However, this example illustrates how a Roth transition at this stage of life has the potential to significantly reduce your after-tax income in retirement.
Of course, there are circumstances where a late-life Rus conversion might be useful. Most notably, if managing RMDs is your primary concern, you will achieve this through a Roth conversion. You can pass a Roth IRA to your heirs tax-free and use the portfolio as a source of short-term spending without affecting your overall taxable income. But if you want to explore the possibility of a Roth conversion or other aspects of retirement income planning, consider talking to a financial advisor.
You’re never too old to legally complete your Roth conversion. You can do this at any time as long as you have qualified funds in your pre-tax retirement account. But the closer you get to retirement, the more likely it is that Rose’s transition will lose some of its luster.
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Rose’s transitions may not always make sense, but that doesn’t mean they don’t have a place. Converting a traditional IRA or 401(k) to a Roth IRA can save you taxes and allow for significant tax-free growth over time. The challenge is figuring out what makes the most sense for you. Many people simply look at their current tax rate and compare it to their projected tax rate in retirement to determine whether to perform a Roth conversion. But financial services giant Vanguard Group found that an investor’s personal “break-even tax rate” (BETR) can be a better indicator of whether a Roth transition is worth it.
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A financial advisor can help you create a comprehensive retirement plan. Finding a financial advisor isn’t difficult. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can have a free introductory call with your advisor to decide which one you think is the best fit for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started today.
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Keep an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid—held in an account that is not at risk of large swings like the stock market. The trade-off is that the value of liquid cash may be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts at these banks.
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As of this article I am 65 years old, receiving Social Security and have $830,000 in a 401(k) account. Is it too late to convert to a Roth IRA? appeared first on SmartReads by SmartAsset.