Should I convert my Traditional IRA or 401(k) into a Roth?

Should I convert my Traditional IRA or 401(k) into a Roth?

Millions of Americans have retirement assets in Roth IRAs. Roth 401(k) accounts are less well known vehicles than traditional IRAs, but the rules regarding these vehicles continue to make “Roths” (both 401(k) and IRA) use easier and more popular.  But be careful.  While traditional IRAs and traditional 401(k) accounts both can be rolled over into Roth 401(k) accounts, which requires a current (and often large) payment of taxes, it should be pointed out that Roth IRA accounts cannot be rolled over into a Roth 401(k).

Traditional retirement plan accounts (IRAs or 401(k)s) converted to Roth 401(k) trigger an immediate tax on the amount converted.  But because you’ve paid taxes amounts in Roth accounts, they will grow tax-free and are withdrawn at retirement tax-free (age 59 ½ or older).

Additionally, funds in prior employer Roth 401(k)’s may be rolled into your existing Roth 401(k). Unfortunately, one source of funds that cannot be rolled, transferred, or converted into a Roth 401(k) are Roth IRAs.

We highlight three factors driving whether to convert your traditional retirement accounts into a Roth:

Current vs future tax rates

We can’t know what future tax rates will be. However, if we estimate based on current tax rates and income levels, we can reasonable guess what our future tax rate will be. To the extent that our future (retirement age) tax rate is expected to be much lower than our current tax rate (which tops out at 39.6%), we would tend to favor keeping our money in a traditional IRA or 401(k). To extent our future tax rate is the same or we expect it to be higher (which is unusual) during retirement, we are generally better off converting traditional retirement accounts to Roths.

Investment returns

The higher the expected returns on your retirement savings, the more attractive a Roth will be relative to a traditional retirement plan. Thus if you are risk averse and generating returns of 5% or less, a Roth may not make sense.

Years until retirement

Generally speaking, the longer you can let your retirement savings grow and earn compounded returns, the more likely the benefit of a Roth.

Unique planning idea

We have always thought high earning younger people (35 or younger) suddenly finding themselves out of work should consider converting their Traditional IRA or 401(k) to a Roth. If their income drops, young professionals often find themselves in a low (15%) tax bracket with plenty of time until retirement. Thus the cost to convert to a Roth (current tax due) is relatively low while the time period to make up the smaller Roth balance with compounded returns is long. Of course, paying a tax penalty on rolled over retirement funds may not be a luxury a person can afford after a lay off. But if they can, the benefits are potentially great but only if the person has the savings to pay the taxes, and not withdraw traditional 401(k) or IRA funds (which triggers an additional penalty) to pay taxes upon the Roth conversion.


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