Benefits of Roth conversion

Q – I’ve heard about the benefits of converting a 401(k) into a Roth. When is the best time to do this?

A – One of the unfortunate situations many are in today - including yours truly to some degree – is that they put all or most of their retirement money into tax-deferred accounts; 401(k) or Traditional IRAs, and Uncle Sam can’t wait to tax those large accumulated balances. If you’re in that situation and you haven’t roughly calculated your future tax hit due to the Required Minimum Distribution, thank me for giving you a heads up. The earlier you address this tax problem, the better. While you could convert a $500,000 401(k) to a Roth all at once, that’s a bad idea as it would probably put you in the 35% tax bracket (plus State taxes). Ouch!

So, it’s better to do it a little at a time, across many years, combined with a plan to spend down and withdraw from the 401(k) before the RMDs start (currently age 73 up to age 75 in 2033). I crossed out spend down because you don’t want to spend for the sake of spending, rather get the money out at a lower tax rate and invest it in an after-tax account. What’s less obvious is that it's better to convert more when investments are down. If you 401(k) dropped in value by 20%, you’ll save 20% of the tax due on the conversion. If they’re up 20%, you’ll pay more tax to convert. In summary, convert across as many years as possible, starting as soon as possible, converting more when values have fallen and less when they have quickly risen.

By the way, it is possible when using Roth accounts to get to Zero Tax, as I call it. Where your taxable income is below the standard deduction, thus avoiding federal and likely state tax. It's pretty amazing that you can reach a point where you no longer have to pay the IRS. You’re welcome.