Is It Wise to Convert 20% of My 401(k) into a Roth IRA Each Year to Avoid Taxes and RMDs?

With retirement planning and taxes, there are often two ways to look at a question: First, can you do something, and then, should you do it?

For example, let’s say we have a household planning for retirement. Would it be wise for them to convert their 401(k) into a Roth IRA 20% at a time in order to avoid taxes and RMDs? Technically, this is certainly allowed. You can do this. 

Whether this is wise, that’s a different matter. In general, this plan will work better the younger you are and the less you currently make. On the other hand, the closer you are to retirement or the higher your current income, the more likely it is that this won’t be worth the conversion taxes. As Aaron Cirksena, founder and CEO of MDRN Capital, told SmartAsset, “You have unique challenges that are based on your own situation that need to be considered.”

Pre-tax retirement accounts, like a 401(k), have a rule called the required minimum distribution (RMD). This is the minimum amount you must withdraw from your portfolio each year starting at age 73. As with all pre-tax distributions this adds to your taxable income for the year, which is the entire point. The IRS wants to make sure you pay for your tax-deferred accounts eventually. 

Depending on your circumstances, this can disrupt your financial planning. Some households want to live on other income or assets, letting tax-deferred accounts continue to grow. Others simply don’t need this money and want to leave it to their heirs. Whatever the reason, a required minimum distribution can raise your taxes and shrink this account.

This is where Roth conversions come in.

Like all post-tax portfolios, a Roth IRA is not subject to RMDs. So households trying to avoid minimum distributions often convert 401(k)s into a Roth IRA. You can do this at any age and in any amount. The only significant requirement is that the assets must come from a pre-tax portfolio, and the converted assets cannot themselves be a required minimum withdrawal. 

Roth conversions have significant and immediate tax implications. Consider reviewing the best options for your situation with a financial advisor who is obligated to work in your best interest.

A Roth conversion has two major downsides to consider.

First, there is the five year rule. When you convert funds from a pre-tax portfolio to a Roth IRA, that money must stay in place for at least five years or until you turn 59 1/2. While not a problem for most households, it’s still important to consider, especially if you plan to retire soon and will need the income soon.

Then there’s taxes. When you convert assets to a Roth IRA, you include that amount in your taxable income for the year. For example, say that you convert $250,000 worth of securities from a 401(k). Absent special circumstances or other income, you would owe about $54,547 on that transfer. 

There are many ways to manage this tax event. When possible, for example, it’s best to convert a pre-tax account earlier in life. The longer you wait, the more that account will grow and the more taxes you will pay on those returns. It’s also helpful to convert your money in stages. By converting less money each year, you can reduce your tax rates and the overall amount you pay. 

For example, say that you have $1 million in your 401(k). If you convert this portfolio all at once, you will pay an effective federal tax rate of 32.52%, or about $325,208 in taxes.  On the other hand, say that you convert it $200,000 at a time. You would pay an effective rate of 19.2%, or $38,400 per year, for a total tax bill of $192,000.

Note that this estimation doesn’t include any applicable state or local taxes, growth on your portfolio, or other nuances. A fiduciary financial advisor can help you calculate the math with more accuracy.

So, if you can convert your 401(k) to avoid RMDs and taxes, the real question is… should you? Let’s return to your example. Say that you have a 401(k). Should you convert it 20% at a time, over five years, to a Roth IRA?

The answer, Cirksena said, is… it depends. 

“This is 100% dependent on one’s income situation and projected retirement income. In theory, yes, it makes sense to start limiting the amount of money we have in our pre-tax retirement accounts. However, there are many variables that need to be considered first.”

The younger you are, and the lower your current income, the more likely it is that this strategy will work, because you can maximize your Roth’s potential for tax-free returns. If you’re a younger worker, converting your 401(k) to a Roth portfolio can have enormous advantages down the road.

“A Roth account needs time to grow and take advantage of the long-term tax savings. If you don’t have at least 10 years before you need to pull money from this account, it likely doesn’t make sense to convert,” said Cirksena. 

This is also true if you currently make less than you expect to draw down in retirement. A Roth portfolio is effectively a form of tax arbitrage. You pay taxes at your rates today in exchange for not paying taxes at your rates in retirement. The cost of this arbitrage is that the tax money you pay today is all capital that you could have otherwise invested. This generally works in your favor if you pay lower rates today to save on higher rates later in life.

For example, say that you’re 30, earning about $50,000 per year with the same amount saved in your 401(k). You’re paying an effective 8.24% tax rate. Converting $12,500 per year would only push your taxes from $4,811 to $6,011 per year, or about $6,000 in total conversion taxes. Since you’re likely to withdraw a higher income in retirement, and pay higher taxes, this is probably worthwhile. 

On the other hand, say that you’re 67 with about $100,000 per year of retirement income and $1 million in your 401(k). If you withdraw this money as income over 10 years, you would pay $14,261 per year, or $142,610 total. On the other hand, if you convert this portfolio 20% at a time, you would pay $57,786 in conversion taxes each year, for a total of $288,930.

At this stage of life, you will pay twice as much in taxes to convert this portfolio than you would to live off it. But again, this is an oversimplified example. A financial advisor can help you determine what the tradeoffs might look like for you with this strategy.

That’s not to say there are no circumstances where a mid-retirement conversion is worthwhile. That’s particularly true if you would like to leave this money to your heirs, since a Roth IRA is a significantly more valuable inheritance than a 401(k). As far as managing your taxes and RMDs, though, whether it’s wise to convert a pre-tax portfolio depends on where you are in life.

Is it wise to convert your 401(k) to a Roth IRA 20% at a time? While this is a good way to manage the taxes of a Roth conversion, whether that conversion is wise overall depends a lot on your personal financial situation and how close you are to retirement.

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