A couple considers how much they could pay in taxes if they roll $720,000 into a Roth IRA.
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Taxes are a valid concern if you want to transfer $720,000 from your retirement fund to a Roth IRA. While you won’t pay any taxes if the assets you’re rolling over are held in another Roth account, there’s typically no way to completely avoid paying taxes when transferring pre-tax money to a Roth IRA. However, with some strategic measures, it is possible to limit today’s tax problems while reaping the benefits of tomorrow’s tax-free benefits. To determine if a Roth rollover aligns with your overall savings and tax strategy, consider crunching the numbers with a financial advisor who is in tune with your financial situation and retirement vision.
A Roth IRA is a retirement account that allows people to contribute after-tax dollars. Unlike a traditional IRA, you don’t get a tax break on Roth contributions. However, qualified Roth withdrawals in retirement can be taken tax-free. This differs from traditional IRAs, whose contributions are often tax deductible but withdrawals are taxed as ordinary income.
Generally, you can transfer funds from another retirement account, such as a traditional IRA or 401(k), to a Roth IRA. This is called a Roth conversion or Roth rollover. When you convert funds, you owe income taxes on the amount transferred for that year. So, if you transfer $50,000 from a traditional IRA to a Roth IRA, the $50,000 is added to your taxable income for the year.
It’s important to understand that Roth rollovers are not the same as Roth contributions. Higher-income taxpayers may not qualify to make direct Roth contributions. However, there are no income limits for making Roth conversions from other accounts.
You can transfer funds from 401(k), 403(b), 457, traditional IRAs, SEP IRAs, and simple IRAs. To start the process, contact the institution that owns the account you want to transfer and convert. They can help facilitate the transfer. You typically have 60 days to complete the conversion; Otherwise, the IRS will treat the rollover as a distribution and you could receive a 10% early withdrawal penalty. But if you need additional help determining how much to renew and convert, consider speaking with a financial advisor.
Transferring assets to a Roth IRA will trigger taxes, but it will also trigger tax-free growth and withdrawals.
There are a few key reasons why a person might choose to do a Roth conversion:
Tax-free growth: Money that is converted to a Roth IRA grows tax-free. This differs from traditional IRAs whose investment earnings are tax-deferred but eventually pay taxes when withdrawn. Roth withdrawals will be 100% tax-free, as long as you meet the five-year rule and are age 59.5.
Avoid RMDs: Traditional IRAs are subject to required minimum distributions (RMDs) – required withdrawals that begin at age 73. For those who do not need these distributions, RMDs can generate excess taxable income. However, Roth conversions eliminate future RMDs, since Roth accounts are not subject to these rules.
Tax savings: Paying conversion taxes now may make sense if you expect to be in a higher tax bracket when you retire. Roth conversions lock in current rates. They also reduce future RMD amounts that could push you higher.
estate planning: Heirs who inherit Roth IRAs can potentially extend tax-free distributions over their life expectancy, depending on their relationship to the person who died. However, some beneficiaries will need to empty the account within 10 years.
As you can see, there are some good reasons to convert an IRA or 401(k) to a Roth IRA, but a financial advisor can help you explore how such a transaction may affect your finances and tax liability.
When doing a Roth conversion, the main drawback is the tax liability. However, there are some strategic measures to potentially reduce taxes:
Partial conversions: One method is to do partial Roth conversions over several years instead of converting the entire balance at once. The idea is to convert enough each year to “fill” your current bracket with income while avoiding a higher bracket.
Low tax years: In low-income years it may make sense to convert larger sums. This could be an early retirement before RMDs or Social Security begin. Again, the goal is to add enough additional income to fill out your current tax bracket without pushing you into the next tax bracket.
Use non-retirement assets: Many experts suggest paying conversion taxes with non-retirement funds instead of IRA assets. This allows your entire IRA balance to be rolled over to the Roth account and continue to grow tax-free.
If you need help determining which strategy is best for you, consider using this free comparison tool to connect with a fiduciary financial advisor.
A person calculates how much they could end up paying in taxes on a Roth IRA rollover.
As an example, consider a single-filer taxpayer who wants to transfer $720,000 from an old 401(k) to a Roth IRA. Here are some scenarios to think about:
Converting the full $720,000 would potentially result in a tax bill of nearly $220,000 at the current top marginal rate of 37% (assuming the $14,600 standard deduction is taken). That lump sum must be paid during the year in which the conversion is completed.
Completing a series of conversions each year for 10 years controls jumps in tax brackets and spreads the tax impact over a decade. An annual conversion of $72,000 would put you in the 22% group if you have little or no additional income. That translates to a tax bill of about $7,700 per year or $77,000 over 10 years, less than half of what you’d pay in a lump-sum conversion. Keep in mind that your balance will potentially continue to grow over these 10 years, requiring additional conversions and more taxes to pay.
By maximizing conversions during years when your income declines, you can take advantage of being in a lower tax bracket. For example, let’s say you earn $60,000 in taxable income in a typical year, which puts you in the 22% bracket and results in a tax liability of about $5,200 after taking the standard deduction. If you also convert $72,000, you’ll move up to the 24% bracket with $132,000 in total taxable income. You would see your tax liability increase to around $21,000. Do this two years in a row and your combined tax bill will be about $42,000.
But let’s say you will only receive $30,000 per year because you are taking a six-month sabbatical. You could skip the previous year’s conversions and convert two years’ worth, or $144,000, into the gap year. That year, you’ll have an income of $174,000, including $144,000 in conversions and $30,000 in salary. This would put you in the 24% bracket and result in a tax bill of approximately $31,000. Add in the $5,200 tax bill from the previous year and your two-year tax bill could end up being around $36,200. A financial advisor can help you evaluate whether this strategy may be an option for you.
Using non-IRA funds to pay your tax bill in a conversion allows the full amount of the rollover to go into the Roth account. If you use taxable funds instead of IRA funds to pay all taxes due on a $720,000 lump sum conversion, that’s $227,000 more you’ll have growing tax-free in your Roth.
Roth rollovers can reduce future taxes and eliminate RMDs in retirement, at the cost of paying more taxes today. Strategic partial conversions completed over several years, conversions timed with low-income years can potentially limit tax pain, as can the use of non-retirement assets to pay conversion taxes. Consult with financial and tax professionals to design a smart approach to taxes.
With a big retirement move like a Roth conversion, it’s helpful to sit down with a financial advisor who can discuss your entire financial picture. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors serving your area, and you can take a free introductory call with your matched advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
It’s important to have an idea of the progress you’re making when planning and saving for retirement. SmartAsset’s free retirement calculator can help you estimate how much money you may need to save for retirement and whether you’re on track to reach that goal.
Keep an emergency fund on hand in case you have unexpected expenses. An emergency fund should be liquid, in an account that is not at risk of significant fluctuations like the stock market. The downside is that inflation can erode the value of liquid cash. But a high-interest account allows you to earn compound interest. Compare savings accounts at these banks.
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