Q: I’m planning on retiring in three years, and my plan is to move my 401(k) into a Roth IRA. Do I have to move the entire account in one year? Or, can I move a portion each year so I can soften the impact on my income taxes?
A:The simple answer, Jeff, is yes, but there are crucial factors that you should consider before you make the move.
Converting money from a traditional 401(k) or IRA has a great deal of appeal for most people. You pay income taxes on your retirement money today in exchange for the promise of tax-free income in the future.
I’ve been a practicing financial adviser since before Roth IRAs were created. I’ve seen some Roth conversions that were done brilliantly, and yet I’ve witnessed others where the Roth conversion essentially guaranteed that the account holder would be paying higher taxes than were necessary. As with so many other things, the key here is to do the proper planning.
Basic math states that if you convert while in a low tax bracket, and yet you expect to be in a higher tax bracket in the future, the conversion makes sense. Conversely, if you are in a higher tax bracket today, but will be in a lower tax bracket in the future, converting to a Roth IRA would be foolish.
The reality, however, is that determining what amount, if any, should be converted to a Roth is a bit more complicated than predicting future tax brackets.
Our income tax structure is highly progressive—not in the sense that it’s forward thinking and getting better each year, but progressive in that as a person’s income rises, so do the tax rates.
Depending upon your income when you convert some money from a 401(k) to a Roth IRA, you could pay anywhere from no income taxes at all, to as much as 39.6% of what you convert. Plus, if you live in a state with high income taxes, like New York or California, you could be forced to pay north of 10% in state taxes in addition to what you’ll pay Uncle Sam. (Most Americans’ marginal federal tax rate is 15% or lower.)
While it’s true that a very small percentage of people are taxed at the highest rates, income tax is based upon one’s income for each calendar year. So, if a person who has been in a lower tax bracket for years suddenly converts a large 401(k) accumulated over many years to a Roth IRA, that individual could pay taxes on some of those converted dollars at the same rate as a Donald Trump. That’s right. A person who is nowhere near the top 1% in yearly income could pay income taxes like those with massive incomes (without the penthouse or helicopter, obviously).
One thing that is often overlooked is the state taxes that are owed upon a conversion. Withdrawals from retirement plans such as 401(k)s and IRAs are taxed based upon where the individual is living when the withdrawal is made. So if a person works in California his entire career, but then moves to a zero-income tax state, such as Florida or Texas, they can avoid paying state income taxes on their withdrawals.
Similarly, doing a Roth conversion while living in a high-tax state may be a mistake if you plan on moving to a low-tax state during retirement, even if you believe that federal income tax rates may be higher in the future.
From my experience, the best way to do a Roth IRA conversion is to do some income tax planning near the end of each calendar year to see where your taxable income will fall. If your income is in the 15% tax bracket, or lower, take a look at how much can be converted without bumping you up into the 25% tax bracket (the next bracket up the tax ladder), and then convert only that amount. The following year, do the same.
If, after calculations, you find that you are already into the 25% tax bracket (or higher) prior to any conversion, than you’ll want to do some longer-term planning to see what your income might look like several years out. For example, if you have a very large 401(k) balance, and you are under age 70½, you may choose to convert while in a higher bracket so as to lessen the pain when you will be required to take minimum withdrawals each year.
Doing the tax planning each year may sound like a lot of work, but there are really no shortcuts. Furthermore, the simple online calculators don’t do justice to the analysis that must be done. Get yourself a good tax accountant, or, if you do your own taxes, do some “what-if” analysis to determine how much of your 401(k) should be converted.
One last thing: Given your desire to convert your 401(k) to a Roth IRA, it may be in your best interest to convert your 401(k) to an IRA Rollover account once you retire. This would simplify the process when converting some of your account to a Roth each year.
Scott Hanson, CFP, answers your questions on a variety of topics and also co-hosts a weekly call-in radio program. Visit MoneyMatters.com to ask a question or to hear his show. Follow him on Twitter at @Scotthansoncfp