Is a 401(k) Roth Conversion Worth It?

Retirement planning for high-net-worth individuals often involves several different strategies to help optimize your retirement savings. One option that many investors explore is the possibility of converting a traditional 401(k) to a Roth account. This conversion can offer long-term tax benefits in certain situations, but also requires careful planning and an understanding of the potential costs.

In this article, the retirement planning professionals at Avidian will explore whether a 401(k) Roth conversion might benefit you by examining what it entails, the tax implications, the 5-year rule, and any potential downsides that you need to be aware of.

What is a 401(k) Roth conversion?

A 401(k) Roth conversion involves transferring funds from a traditional 401(k) to a Roth IRA or Roth 401(k). Traditional 401(k)s are funded with pre-tax dollars, meaning the contributions you make reduce your taxable income for the year. However, when you withdraw funds in retirement, you pay taxes on both your contributions and any investment earnings.

In contrast, Roth accounts are funded with after-tax dollars, so contributions do not reduce your taxable income. The major benefit comes when you retire — withdrawals from a Roth account are typically tax-free, provided certain conditions are met. A Roth conversion involves transferring the pre-tax dollars from your traditional 401(k) into a Roth account, at which point you’ll owe taxes on the amount converted.

This strategy appeals to investors who anticipate being in a higher tax bracket during retirement. By paying taxes now, at a potentially lower rate, you may avoid higher taxes on your retirement withdrawals later. However, the decision to convert is more complex than it appears, and it requires consideration of various factors, including your current financial situation and future tax projections.

Learn more about how to reduce taxable income for high-income earners

Can I convert my 401(k) to a Roth to avoid paying taxes?

A common misconception is that converting a 401(k) to a Roth allows you to avoid paying taxes; but this is not the case. In fact, when you convert a traditional 401(k) to a Roth, you must pay taxes on the amount you convert. This is because the funds in your 401(k) were contributed pre-tax, meaning you haven’t paid income taxes on them yet. When those funds are transferred into a Roth account, the IRS treats it as taxable income.

The benefit comes down the road when you start withdrawing from the Roth account. After the conversion and after you’ve paid taxes, any future withdrawals from the Roth account are generally tax-free, including any investment gains. This is why many people opt for a Roth conversion — they’re willing to pay taxes now to potentially enjoy tax-free income in retirement.

How much can I convert from my 401(k) to a Roth IRA?

The amount you can convert from your 401(k) to a Roth IRA isn’t capped by IRS contribution limits like standard Roth contributions are. You can convert as much of your 401(k) as you want in a single year, but there’s a catch: the more you convert, the higher your taxable income for that year.

This increase in taxable income could potentially push you into a higher tax bracket, so many investors choose to spread conversions over several years. A gradual conversion strategy may help you manage your tax liability more effectively while taking advantage of the benefits of a Roth account.

Learn more about what happens to your tax liability with proper financial planning

What is the 5-year rule for Roth conversion?

The 5-year rule is an important aspect of Roth conversions that many investors may not be aware of. Essentially, it stipulates that you must wait five years after the conversion before you can withdraw the converted funds (tax-free) from your Roth account without penalty, regardless of your age. This rule applies to each conversion you make, not just the first one, so if you convert funds in multiple years, the 5-year clock starts over with each conversion.

This rule is designed to prevent people from using Roth conversions as a quick way to avoid paying taxes on large withdrawals. If you withdraw converted funds before the 5-year period is up, you may be subject to penalties and taxes, even if you’re already past the age of 59½.

It’s also important to note that this 5-year rule only applies to the converted amounts, not to the earnings on those amounts. The earnings still follow the standard Roth IRA rules, which allow tax-free withdrawals after age 59½, as long as the account has been open for at least five years.

How does the 5-year rule work for Roth conversions?

For example: Let’s say John, age 45, decides to apply $50,000 from his traditional 401(k) to a Roth conversion in 2024. Under the 5-year rule, John must wait until at least 2029 before withdrawing the converted $50,000 without facing taxes or penalties on that amount. This 5-year waiting period applies even though John is older than 59½, because the rule applies specifically to converted funds, not earnings.

If John withdraws the converted $50,000 before the five years are up, he could face a 10% early withdrawal penalty on the converted amount, since he hasn’t met the 5-year holding requirement.

The 5-year rule aims to prevent quick tax-free withdrawals after a conversion, helping to ensure that the Roth conversion is used for long-term tax planning. 

It’s also important to note that each conversion has its own 5-year clock. If John makes additional conversions in subsequent years, each one will start a new 5-year waiting period. However, once the 5 years are up for a particular conversion, John can withdraw those funds tax- and penalty-free, as long as other withdrawal rules are followed.

What is the downside of Roth conversion?

While a Roth conversion offers several advantages, it’s not without its downsides:

• Immediate tax liability: Since the funds in a traditional 401(k) are pre-tax, converting them into a Roth account means you’ll owe taxes on the entire converted amount in the year the conversion takes place. This can lead to a substantial tax bill, particularly if you’re converting a large amount.
• Potentially higher tax bracket: Moreover, the tax liability could push you into a higher tax bracket for the year, meaning you’ll pay a higher tax rate on both the converted funds and any other income you earn during that year. To mitigate this risk, many investors choose to convert smaller amounts over several years, spreading out the tax burden.

Can I reverse my Roth conversion?

Previously, investors had the option to reverse or “recharacterize” their Roth conversions if they found that the tax liability was too high. This option allowed individuals to undo a Roth conversion and put the funds back into a traditional 401(k) or IRA, which would eliminate the immediate tax liability. However, as of 2018, the IRS no longer allows Roth conversions to be reversed. Once you’ve completed a conversion, it’s permanent, and you must pay the associated taxes.

This change makes it crucial to carefully consider the timing and amount of any Roth conversion. Without the option to reverse, you’ll want to be confident that the benefits of the conversion outweigh the immediate tax costs.

Is it worth converting 401(k) to Roth? Let’s talk about it.

So, is a 401(k) Roth conversion worth it? As is often the case, the answer largely depends on your individual circumstances, including your current and expected future tax rates, your retirement timeline, and your overall financial situation. For some, paying taxes now to potentially enjoy tax-free withdrawals later can be a wise strategy, particularly if you expect to be in a higher tax bracket in retirement. For others, the immediate tax burden may outweigh the long-term benefits.

Additionally, if you don’t anticipate needing your retirement funds for at least five years, a Roth conversion may make sense because it gives the converted funds time to grow without tax liability. However, if you plan to access your retirement funds sooner, you’ll need to carefully consider the 5-year rule and the associated penalties.

If you’re contemplating incorporating a 401(k) Roth conversion into your retirement plans and want to explore your options, contact a retirement tax advisor from Avidian Wealth Solutions today. Let’s work together to create a retirement strategy that aims to maximize your tax efficiency and set you up for a more financially secure future.

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