There is no age limit for Roth conversions, so you can transfer pre-tax savings to a Roth IRA regardless of your age or retirement status. As long as you have qualified funds in a pre-tax portfolio, you can transfer them to an after-tax Roth account.
A financial advisor can help you make important decisions about your retirement account, such as whether to do a Roth conversion. Contact a fiduciary advisor today.
That doesn’t mean that conversion always makes sense. For retired households, the benefits of a Roth conversion are often relatively small compared to the costs of the conversion. Let’s say you’re 65, receiving Social Security, and have $830,000 in your 401(k) account. Technically, you are completely free to do a Roth conversion. However, in practice it may not bring the financial benefit you expect.
What is a Roth Conversion?
A Roth conversion refers to the process of transferring funds from a qualified pre-tax retirement account, such as a 401(k) or traditional IRA, to a Roth IRA. There’s one important caveat: the transfer requires you to pay income taxes on the money you’re exchanging.
When you contribute to a pre-tax account like your 401(k), you get a full tax deduction for the amount invested. Then, in retirement, you pay income taxes on all withdrawals (both earnings and capital). However, when you contribute to a Roth IRA, you do not receive any tax benefits on the amount invested. In return, qualified withdrawals can be made completely tax-free. Roth accounts are also not subject to required minimum distributions (RMDs) because the money has already been taxed.
The main advantage of a Roth IRA is that your portfolio grows completely tax-free. If you invest $1,000 and the amount grows to $10,000, you will only pay taxes on the $1,000 before it is credited to your account. With a pre-tax portfolio, however, you have more capital available to invest from the outset. Every dollar you don’t pay taxes on is a dollar that can grow over time.
Consider speaking with a financial advisor if you need help managing your retirement savings or deciding between pre-tax and Roth accounts.
Tax implications of a Roth conversion
When you do a Roth conversion, every dollar converted is added to your taxable income for the year. Those under age 59 ½ need another source of liquidity to pay these taxes. However, if you are 59½ or older, you can pay these taxes with money from your portfolio. However, keep in mind that this will reduce the value of your portfolio and its potential for long-term growth.
Say you convert $830,000 from your 401(k) into a Roth IRA. Additionally, imagine that your income is equal to the average U.S. household income of around $75,000. A blanket conversion would increase your marginal tax rate from 22% to 37% and potentially cause you to pay hundreds of thousands in federal taxes. On the other hand, you would never pay taxes on that money again, giving you access to tax-free returns and withdrawals later in life.
Finally, all Roth conversions have a five-year cooldown period. This means you must keep the money and associated earnings in place for five years after the transfer. Fortunately, a financial advisor can be a valuable resource if you need help with a Roth conversion or navigating the tax rules of Roth IRAs.
Roth conversions in retirement
Late-stage Roth conversions are a common question. People often ask whether they can transfer their retirement savings to a Roth account. That’s the wrong question. The real question is: should they?
As a rule of thumb, a Roth portfolio is most useful when your current tax rate is lower than your expected tax rate in retirement. This is also most useful when your portfolio has more time to grow, allowing you to maximize the value of these untaxed returns.
In contrast, a pre-tax portfolio may be a better option if you currently pay higher taxes than you would in retirement. This allows you to defer your current (higher) taxes until later in life when you pay a lower tax rate.
In our example, let’s assume that you are 65 years old and have already started receiving social security contributions. If you’re not fully retired yet, you probably will be soon. You have to spend a lot of tax money up front to make the switch, which significantly reduces the long-term growth potential of your portfolio.
For example, let’s say you spread your conversion over five years (the equivalent of $136,084 per year) to avoid a lump sum conversion. Let’s assume you get a mixed asset return of 8% over this period. This is how it could turn out:
Without Roth conversion
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401(k) value at 70: $1.23 million
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Portfolio income at 70 (using the 4% rule): $49,500
With annual Roth conversions
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Roth score at 70: $800,000
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Portfolio income at 70 (using the 4% rule): $32,000
This example does not take into account the growth of your 401(k) account during this five-year conversion, meaning you would have to do additional conversions to completely drain the pre-tax account. It also does not take into account the taxes that would apply to pre-portfolio withdrawals. However, this example shows that Roth conversions at this stage of life have the potential to significantly reduce your after-tax income in retirement.
Of course, there are some cases in which a Roth conversion late in life can make sense. Especially if managing RMDs is your biggest concern, you can accomplish this with a Roth conversion. You can pass a Roth IRA to your heirs tax-free and use the portfolio as a short-term source of spending money without affecting your overall taxable income. However, if you want to explore the possibility of a Roth conversion or other aspects of your retirement income plan, you should consider speaking with a financial advisor.
Bottom line
You are never too old to legally complete a Roth conversion. You can do this at any time as long as you have qualified funds in a pre-tax retirement account. But the closer you get to retirement, the more likely it is that a Roth conversion will lose some of its luster.
Roth conversion tips
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Roth conversions 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 pay dividends over time in tax savings and significant tax-free growth. 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 decide whether or not to do a Roth conversion. However, financial services giant Vanguard has found that an investor’s individual “break-even tax rate” (BETR) can provide a better indication of whether a Roth conversion is worth it.
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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 connects you with up to three verified financial advisors working in your region, and you can have a free discovery call with your matching advisors to decide which one you think 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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