Should You Convert Your Tax-Deferred Savings to a Roth IRA? Consider These Key Points

Achieving financial adaptability during retirement—particularly by increasing your expenditures while reducing your tax liabilities—is considered ideal.

Plus, it involves setting up an arrangement where a portion of your retirement funds stays within a tax-free account.

"You're providing yourself with additional choices down the road," stated Brian Kearns, an Illinois-based certified public accountant and certified financial planner.

A method to achieve this is by transferring part of your tax-deferred funds from your 401(k) or conventional IRA into a Roth account. Funds moved into Roth 401(k)s and Roth IRAs accumulate without taxes and can be taken out tax-free provided they remain in the account for a minimum of five years following the transfer.

Unlike contributing to a Roth IRA annually with new deposits, which has income limits, there is no restriction based on income for converting traditional retirement savings into a Roth account or for regularly adding funds to a Roth 401(k).

An additional benefit is that during retirement, you have the flexibility to choose both the amount and timing of your withdrawals from your Roth account. Conversely, with tax-deferred savings found in traditional IRAs or 401(k)s, you're required to begin making withdrawals. required minimum distributions at age 73.

That said, Roth conversions aren’t the right answer for everyone. Here is a look at what to consider before making a move.

The basics

Most 401(k) plans (93%) permit individuals to establish a Roth 401(k) account as part of their plan; furthermore, 60% of these plans also support what’s known as "in-plan Roth conversions," reports the Plan Sponsor Council of America.

An in-plan conversion allows you to opt for converting part or all of your deferred-taxed savings into post-tax Roth savings.

Here's what you need to know: When converting funds, remember that you must cover the income taxes due on the converted amount during the same year as the transaction. This often leads many individuals to consider their ability to settle this tax liability before deciding how much to convert at once. As explained by Tara Popernik, who heads up wealth strategies at Bernstein Private Wealth Management, determining the right conversion amount frequently hinges upon having sufficient resources set aside for paying those associated taxes.

Say you convert $100,000 this year. That amount is added to your gross income and may end up pushing you into a higher tax bracket. So, say you’re normally in the 22% federal bracket, it could push you into the 24% bracket. And that means on top of the taxes you owe on your annual income, you might owe an additional $24,000 (24% x $100,000) plus any applicable state income tax.

6 questions to consider

If there was ever an occasion to seek advice from a Certified Public Accountant (CPA) or a certified financial planner with expertise in taxes who has assisted numerous clients in evaluating Roth options, now would be that moment. (These professionals can also aid you in determining if converting makes sense, particularly considering potential extensions of certain 2017 tax provisions that may expire later this year.)

However, broadly speaking, here are some queries to ponder when determining if switching over would be a prudent step:

1. Are you anticipating an increase in your earnings leading up to retirement? If you're early in your career, your income is expected to increase from where it stands today until retirement. This progression could push you into a higher tax bracket down the line. Therefore, converting earlier may prove more beneficial as your taxes would be relatively lower now and your post-tax savings would get additional time to accumulate without taxation.

2. Are you able to cover the upfront tax payment? Ideally, you should possess sufficient funds readily available to cover that single tax payment — money that will be not required for present daily costs, future financial obligations, or unexpected events.

Popernik advised that if raising funds becomes necessary, one should aim to steer clear of selling assets that could trigger capital gains taxes. This precaution helps maintain the benefit gained from conversion.

Similarly, in most cases, using your tax-deferred retirement funds to cover the cost of converting them would also not be advisable—especially if you're younger than 59½, as this would result in both a 10% early withdrawal penalty and additional income taxes.

Once more, rely on your tax advisor to assist you in determining which, if any, cash-generation approach is appropriate for your situation. Should it happen that settling a large tax bill from a single conversion proves financially straining, and you have the choice to contribute to a Roth 401(k), consider starting regular after-tax contributions to this account moving forward. Alternatively, income is low enough , you can open your own Roth IRA.

3. Are your taxes expected to increase after you retire? A puzzler indeed. The sole genuinely accurate response remains "Who knows?"

However, according to our current tax system, you can generally predict future developments if the global scenario—and the U.S. tax code—don’t make a full reversal.

Generally speaking, if you anticipate your income taxes will be higher in retirement than now, converting tax-deferred savings to a Roth is likely advantageous.

By converting earlier, you're apt to gain maximum value from it. As Popernik noted, "The longer the funds remain invested in the Roth, the greater the advantage."

4. What is the optimal timing for conversion from a market perspective? A recent analysis conducted by Bernstein Private Wealth Management indicates that the optimal moment for converting your tax-deferred funds into a Roth account is when markets are down If you follow this advice, you'll maximize the value of your taxes. By purchasing assets via a Roth during downturns, "the profits generated once the economy recovers can accumulate in a tax-exempt setting," as the report pointed out.

It's important to note that predicting market troughs and peaks is extremely difficult. Furthermore, the Bernstein study revealed that even converting assets when their values are at an apex could potentially result in significant long-term tax-free benefits, making such a move worthwhile.

5. Which revenue streams do you plan to rely on after retirement? A method to estimate your tax liabilities during retirement compared to today involves assessing a) the amount of income required for living expenses; and b) where this income will come from, remembering that different types of income may have varying taxation rules.

For example: Will you earn income from a pension alongside your Social Security benefits? Will you get rental income from a property? Will you withdraw taxable income such as interest and dividends? Or will you rely on tax-exempt interest from municipal bonds?

Having both taxable and tax-free savings to draw on can help you optimize your withdrawal strategies. For example, Kearns said, for the years when your taxable income will be lower than other years in retirement, you might pull from your traditional tax-deferred accounts for any money you need on top of your Social Security, because you will be in a lower tax bracket. Whereas in years when your taxable income might be higher — say, when you have to start taking required minimum distributions from an IRA or you’re selling a taxable asset — you might tap your tax-free savings to supplement the money you need for living expenses.

6. Do you want to leave a legacy? Roth accounts offer benefits over tax-deferred accounts when passing money to non-spouse beneficiaries.

Regardless of the type of account they inherit, your beneficiaries are required to withdraw all funds within a decade. However, for conventional tax-deferred 401(k) plans and IRAs, they must make annual withdrawals and consequently owe taxes on those amounts. This could potentially elevate their tax rate, as Kearns noted. "This means they'll face unexpected tax liabilities."

However, with the Roth, individuals not only receive the funds tax-free but also aren't required to make regular withdrawals over the 10-year period; instead, they can withdraw everything at once within those 10 years. ^th In that year, Popernik mentioned. This allows them to enjoy an additional ten years of tax-free growth on their inheritance.

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