Making sense of Roth conversions
Why this strategy may – or may not – be right for you.
In this article:
- Roth conversions are a hot topic – but they’re not for everyone
- Taxes on funds transferred from a tax-deferred account to a Roth could be substantial
- It may take years to make the conversion worthwhile
- Individuals with low or no income can be good candidates to do Roth conversions
- Consult a tax professional along with your financial planner
A roth backdoor for high earners
If you’re mulling a Roth conversion in your 50s or older, when your income may be near its peak, does that mean you shouldn’t convert?
“It depends,” says wealth planner Paul Dau. “The strategy of converting to a Roth from an after-tax 401(k) is not as well known as it should be for high-income earners, provided they have access to an after-tax 401(k),” Dau says.
Companies are increasingly offering after-tax 401(k)s in addition to traditional 401(k)s and Roth 401(k)s. Like a Roth, you pay income taxes upfront on all your contributions to an after-tax 401(k). While you can withdraw after-tax 401(k) contributions tax-free at any time, you will have to pay taxes on the investment growth, even in retirement.
But it does offer a backdoor to a Roth conversion. You can transfer your contributions from an after-tax 401(k) to a Roth IRA while you’re still employed at the firm without it being a taxable event, provided your company’s plan allows for it.
However, you will need to roll over the earnings of the after-tax account to a separate traditional IRA to avoid paying taxes on those. If your plan does not allow you to roll over earnings directly to an IRA, you may end up getting a check for the growth on which you will owe taxes.
Moreover, Dau says as a reminder: “As a high-income earner, you want to max out your traditional 401(k) to lower tax liability as that income is not taxable that year.”
If you consider this strategy, you should review your 401(k) plan’s distribution terms and consult with a tax professional along with your planner to determine if the strategy makes financial sense.
To better understand the impact a Roth conversion will have on your retirement and your overall finances, please consult with both a tax professional and your financial planner.
Neither Edelman Financial Engines nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from your qualified tax and/or legal professionals to help determine the best options for your particular circumstances.