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Procedurally, it’s never too late to make a Roth conversion. The IRS allows you to move this money at any time, so long as you have funds in a qualifying pre-tax account.
In many cases though, the closer you are to retirement, the likelier a Roth conversion could cost you big. This doesn’t mean that it’s a bad idea. In fact, many retirees convert their money to a Roth IRA in order to maximize the value of their estate. However, it does mean that you may pay more in conversion taxes and opportunity cost than you save in long-term income taxes, depending on your circumstances.
For example, say you’re 63 years old. You have $1.4 million in a 401(k) and have begun taking Social Security. We’ll outline how to analyze the impact of a Roth conversion in this particular scenario.
To get more tailored guidance, you can also consider working with a financial advisor.
What Is a Roth Conversion?
With a Roth conversion, you move money from pre-tax retirement account into a Roth IRA. This is in contrast to a contribution, which is money you deposit in the account from earned and taxed income. A Roth conversion must use funds from a pre-tax portfolio, like a 401(k) or a traditional IRA. There is no limit on how much money you can convert in a given year, unlike with contributions.
The advantage to a Roth conversion is that once you move over this money, you no longer pay taxes on qualifying withdrawals. This can help you set up a tax-free retirement. The downside of a Roth conversion, however, is that you must pay conversion taxes, and those can be considerable.
What About Roth Conversion Taxes?
When you make a Roth conversion, you must pay income taxes on the amount converted in the year that you make the conversion(s). This total amount is added to your taxable income for the year. In turn, this increases your taxes and, potentially, your tax bracket.
For example, say that you earned $75,000 this year. You also converted $100,000 from your 401(k) to your Roth IRA. Your taxable income for the year would be $175,000.
It’s essential to plan for this impact when you make a Roth conversion. You’ll need extra money to pay these taxes, since that money won’t be automatically withheld from your paycheck. Those over 59 ½ can take this money from the converted funds, withdrawing some money for taxes and converting the rest. But if you are younger, you cannot use the money from your retirement account to pay the conversion taxes. Instead, you must find it elsewhere.
This makes any Roth conversion a tradeoff. You pay taxes today, which reduces the amount of capital you can invest for long-term growth. In exchange, you will pay no income taxes in retirement, which can save you a lot of money.
The rule of thumb is this: The younger you are and the lower your current tax rates, the better a Roth conversion may be. A conversion at this point will give your money more time to grow tax-free. Plus, you’ll pay a lower rate in your up-front conversion taxes. On the other hand, the later you are in life and the higher your current tax rates, the worse a Roth conversion may be. You won’t have as much time to enjoy the tax-free growth, and you’ll pay more upfront taxes in exchange for less long-term savings.
Should You Make a Conversion?
So, in this case, should you convert your money to a Roth IRA?
Here, you are 63 years old with $1.4 million in a 401(k). You’ve also begun taking Social Security benefits. For ease of use, we’ll assume you started taking benefits last year and receive the minimum amount of 70%. Based on an average Social Security check of $1,900 per month, that would give you about $15,960 per year in benefits income. While not nothing, that amount is unlikely to significantly change our analysis.
The real issue here is the 401(k). At this stage, a conversion may cost you more in conversion taxes and opportunity cost than you’d save in future income taxes, depending on your circumstances.
Determine Your 401(k) Tax Liability
Say you currently take portfolio income under the 4% rule. This would give you about $56,000 per year of portfolio income, plus your Social Security, for a combined income of $71,960. You will pay a little less than $7,672 in federal income taxes. (It will be somewhat less because only about 85% of your Social Security is likely taxable. But this is accurate enough for our purposes.) This gives you an after-tax income of about $64,288.
Of this, you are paying an estimated $4,736 per year in taxes on your portfolio income. Over 25 years, this means you will pay, very roughly, $118,400 in income taxes on your 401(k) withdrawals.
Compare That Against Conversion Taxes
On the other hand, say that you convert all $1.4 million of your 401(k) in one year. This would trigger income taxes on the entire amount, and you would pay about $470,784 in conversion taxes. You would pay far more in conversion taxes than you would save in long-term income taxes.
Or, let’s say that make what is called a “staggered conversion.” You move your money in stages, in order to keep your money in lower tax brackets. Say that you convert 10% per year, or $140,000, every year. This would let you finish your Roth conversion just before required minimum distributions (RMDs) kick in in your 70s.
Setting aside other income, this would trigger an estimated $23,138 in income taxes each year. Over the 10 years you make these conversions, you would pay a total of $231,380 in collected income taxes. This is much less than you would pay with a lump-sum conversion, but it’s still more than you would pay in income taxes from your 401(k). (Remember, this example is simplified and doesn’t account for portfolio growth over the years.)
Also Weigh the Opportunity Cost
The above calculations are just a snapshot of the issue. Another major problem is the opportunity cost you will incur by reducing your investible capital. The money you spend on conversion taxes is money that will not remain invested for long-term growth. This is a considerable loss at this stage in life when you have reached the peak of your compounding returns.
Under almost any analysis, we reach the same conclusion: When you are near- or in retirement, you may spend more on a Roth conversion than you will save on income taxes. Ultimately, you need to weigh this decision as a holistic part of your retirement strategy and financial profile to determine the tradeoffs.
How a Financial Advisor Can Help You Decide
At 63 with $1.4 million in a traditional 401(k) and Social Security already in payment, the question is not whether a Roth conversion is legally possible but whether it is financially advantageous given your specific income picture. A financial advisor can calculate your current marginal tax rate with Social Security income factored in, project what your tax rate will look like once RMDs begin at 73 and determine whether a gap exists that makes converting now cheaper than paying taxes on forced withdrawals later.
A $1.4 million 401(k) balance growing for another 10 years before RMDs begin could reach $2.5 million or more depending on returns. At that balance, annual RMDs could exceed $100,000. Those would stacking on top of Social Security income, pushing you into a significantly higher bracket than you’re currently in. A financial advisor can run those projections with your actual numbers and show you whether converting a portion of that balance now, while you are still in a lower bracket, reduces your lifetime tax bill.
Converting while already receiving Social Security introduces a complication that requires careful calculation. Additional taxable income from a Roth conversion increases the portion of your Social Security benefit subject to federal tax, up to a maximum of 85%. A financial advisor can identify the precise conversion amount that stays below the thresholds that would increase your Social Security tax exposure. This would allow you to make a conversion without triggering an avoidable tax increase on income you are already receiving.
Medicare premium surcharges are another real cost that often surprises retirees who convert too aggressively. IRMAA surcharges are based on income reported two years prior, meaning a large conversion at 63 affects your Medicare premiums at 65, right when coverage begins. A financial advisor can calculate the income thresholds for each IRMAA tier and size your annual conversions to stay below the levels that trigger premium increases. Doing this legwork can preserve the tax benefit of converting without adding unnecessary healthcare costs.
Mentioned above, a gradual conversion strategy spread across the years between now and 73 is often more effective than a single large transaction. Converting $100,000 to $150,000 per year in carefully sized increments can reduce the traditional account balance significantly before RMDs begin. This can lower future mandatory withdrawals without creating a single-year tax spike. A financial advisor can build that multi-year schedule, adjusting each year based on your actual income, market performance and any changes to tax law that affect the math.
At 63, you have a 10-year window before RMDs begin, which is enough time to make a meaningful dent in a $1.4 million balance through strategic conversions. Whether that window is worth using depends on the gap between your current tax rate and your projected rate in retirement. Getting this calculation right requires your complete financial picture. A financial advisor can run that analysis and give you a clear answer rather than a general rule of thumb that may or may not apply to your situation.
Bottom Line
It’s never too late to legally make a Roth conversion. However, it can be too late to save money on one. The closer you are to retirement, the more likely it is that a Roth conversion will cost more in conversion taxes than it will save you in the long run.
Tips on Planning Your Retirement Taxes
- Maybe a Roth IRA isn’t your best tax tool. There are still lots of great ways to minimize your taxes in retirement. Start with these common tax breaks for retirees.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard either. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. From there, you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Retirement savings isn’t all you have to worry about it. Keeping an emergency fund on hand is also crucial in case you run into unexpected expenses. An emergency fund should be liquid, meaning it’s kept in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff with these accounts is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
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