Should You Convert Your Rollover IRA to Roth?
I am, once again, flinging myself down the tax rabbit hole that is the Traditional vs. Roth debate.
Why? Because of one simple question on a recent post that I thought was relatively straightforward:
“But if this account is only going to get bigger, shouldn’t I convert it to Roth now while it’s smaller instead of wait until it’s huge?”
As I foamed at the mouth for a chance to explain how Roth conversions actually work in retirement, I sat back for a moment and thought about if there were a better way to demonstrate the dilemma you’ll likely face the first time you go to roll over an old employer-sponsored 401(k).
(For the record, though, it’s generally considered unwise to ever convert an entire 401(k) to Roth all at once – whether you’re young or old – because the entire flippin’ thing gets taxed at your marginal tax rate as if it’s income, meaning you’ll probably get stuck with a fat ass tax bill that you may or may not expect later. It’s almost always a good idea to do it little by little each year, whether that’s now or later.)
Rolling over a 401(k) to an IRA
If you’ve got a 401(k) with an old employer that you’d like to move into your tender loving care as an IRA that you’re managing instead, Capitalize is the easiest (free) way to handle it. I have a full deep dive about the rollover process here, in case you’d like to go read that first.
But let’s say you’ve already decided you’re going to roll over your 401(k) into an IRA – if your 401(k) was Traditional (pre-tax), you may be wondering… Hm, should I keep this as pre-tax money and roll it into a Traditional IRA, or should I convert it to Roth and roll it into a Roth IRA?
Tax-free, penalty-free 401(k)-to-IRA rollovers
Now, the easy, pain-free, math-free way to roll over an old 401(k) into an IRA is to keep the tax status the same. That is to say:
If your 401(k) is Traditional, roll it into a Traditional IRA. No tax bill, no problem.
If it’s Roth, roll it into a Roth IRA.
If it’s both, roll it into both (Capitalize does that for you, if you’re like, “Shit, that sounds complicated,”).
But what if you’re thinking like that person who messaged me? What if you’re thinking you’d rather convert that big ole’ pre-tax 401(k) into Roth now, rather than later?
Why is the timing of a Roth conversion on a 401(k) rollover important?
Well, mostly because of that tax bill.
Today, I want to explore the downstream impacts of converting a 401(k) to Roth in your #youth (all at once) versus waiting until you start taking distributions in retirement (whether you’re a young or old retiree).
When I originally ran some of these numbers, my eyebrows raised. It was more dramatic than I thought.
But as with all things related to tax planning, there needs to be a giant, neon, flashing light above all of this that share one important thing:
So much of these outcomes depend on your personal wealth situation
For the sake of the example, we’re going to have to make some assumptions. Here are a few assumptions we’re making for our projections:
Inflation will increase by 4% per year on average, leading to a decrease in purchasing power (read: when we project outcomes 25 years into the future, it sounds like a lot more money than it actually will be, since your money will likely be worth less in the future).
The tax brackets will adjust accordingly. That is to say: While the equivalent of a $50,000 per year income in 2050 might be $150,000 in 2050 dollars, my assumption is that the tax brackets will shift upward, too. That’s pretty standard; every year the “brackets” go up with inflation. That said, assuming anything about what tax rates will be like in 25 years is somewhat of a gamble, so remember über long timelines like these are meant to paint a conceptual picture and not to predict the future.
The size of your Traditional 401(k) is the biggest factor in deciding whether or not a Roth conversion makes sense for your Rollover IRA
I wasn’t sure how much to use for the hypothetical 401(k) balance, so I looked up the average for the age group 25-34 (as that’s the majority of my audience): $26,000.
That is to say: The average 25-34-year-old has a 401(k) balance of $26,000.
I’ll be using $26,000 for this example, but as with all my #MathShitUp posts, please feel free to whip out a pen, paper, and the SmartAsset Income Tax Calculator that I use for this example and mirror the method to calculate these things for yourself, too. That’ll make this post way more useful.
And if you’re pretty close to the average… congratulations. I did the work for you!
At first, I was going to run this scenario for three different incomes: $50,000, $75,000, and $125,000. I figured that – due to the different marginal tax rates – the outcome would be measurably different, but it turns out your income has a lot less to do with the outcome than the size of the 401(k), within reason. Go figure.
(Obviously, if you make some ridiculous sum that puts you in the top marginal tax bracket, you’re probably in a slightly different situation – but when we’re talking about a tax bill here, the outcomes were within a few hundred dollars of one another.)
That being said, I’m going to #SplitTheDiff and use the $75,000 income.
A person with a $26,000 401(k) to rollover and a $75,000/year income
Here’s what I did:
Plug $75,000 into the SmartAsset tax calculator (and use your actual zip code if you want – if you’re married, you’ll also want to use household income and the correct filing status).
Write down the amount of income tax owed.
Now, add $26,000 (the value of our fake 401(k)) to the income ($75,000 in this case) for a total of $101,000. The government will look at your total income for the year and your “Roth-converted” 401(k) balance together when assessing how much you owe in taxes.
For this example (for a single filer)…
Total tax liability on the $75,000 income alone was $15,300, assuming no other pre-tax contributions or deductions
Tax liability if you convert the entire amount to Roth? $23,070.
That means the tax bill for your Roth conversion is:
$7,770
Yikes. So why is that potentially problematic?
Well, that money has to come from somewhere. And here’s where shit gets interesting.
How do you plan to pay your $7,000 tax bill on the Roth conversion?
On a $26,000 401(k), it’s $7,770.
But what if your 401(k) was $50,000? Or $60,000? Converting it all at once means you’d be looking at a tax bill of $11,000 or $13,200, respectively.
Imagine you’re filing your taxes in April unaware that this is coming: You blissfully enter the information from all the forms you received for tax season, and there it is, staring back at you: You owe $12,000.
Would that be a, “Holy shit,” moment? It would be for me, which is why tax planning is so crucial.
The bottom line: That tax money has to come from somewhere, and often times people are forced to actually use the money in their new rollover Roth IRA to pay the taxes they owe on the conversion.
That’s basically the worst case scenario. Why?
Because if you converted $26,000 to Roth and had to withdraw $7,770 in April to pay the tax bill on the conversion, you now lose roughly 30% of your account’s total value.
That may not seem like that big of a deal, but small deals become big deals when they compound over 25 years.
After 25 years, your rollover IRA with $26,000 in it would become $141,113 assuming a 7% rate of return.
If you had converted it to Roth and end up needing to use some of the account’s money later to pay the unexpected tax bill, you’re left with $18,230 in the account – that only becomes $98,942 after 25 years, or $42,171 less.
Depleting the account value by 30% when you’re young costs you $42,000 over 25 years of compounding (if you start with $26,000).
It’s even more barf-inducing when you look at, say, a 40-year timeline:
Roughly $18,000 (your Roth IRA minus the money you used to pay the tax bill) left alone for 40 years becomes $278,000.
But had it stayed in its entirety? $26,000 left alone for 40 years becomes a whopping $389,000.
To pay the tax bill with money from inside the account cuts your value by more than $100,000 over 40 years – all for a $7,000 tax bill.
Moral of the story? Don’t use the money in the account to pay the taxes.
But this alludes to a broader issue with Roth conversions in your youth if you’re paying a high marginal tax rate on the entire thing: Opportunity cost.
(If you’re like, “How do I know if I’m paying a high marginal tax rate?” Google “2021 tax brackets” and find your income – if it’s in the 24% bracket or higher, I’d consider that a pretty damn high marginal rate.)
Even if you plan ahead and manage to set aside the hypothetical $7,000, it has to come from somewhere
$7,000 when you’re 25 is way more valuable to you than $7,000 when you’re 50. Why? Because at 25, you have HELLA TIME on your side.
You saw the impact of a $7,000 loss early on – more than $100,000 over 40 years!
The tricky thing to remember here is that even if you do get the $7,000 from a savings account or a taxable brokerage account, you’re still robbing yourself of the ability to allow that $7,000 to compound for the next four decades.
$7,000 compounding over 40 years at an average annualized rate of return of 7% is worth about $105,000 on its own – it doesn’t have to be part of a larger account to achieve the same outcome (I looked up once why this is; it doesn’t make natural sense to me since my brain is not #organically good at math, but someone on Reddit said some shit about how “interest is a transitive property,” so… there you go).
The only way I could justify performing a big Roth conversion in my current tax year (in this hypothetical) would be if the $7,000 came from money that was earmarked to be spent. If you were planning to spend the money and instead use it to pay your taxes, then there’s no opportunity cost – it was going to be spent anyway. But if you’re dipping into money you would’ve invested to pay it, the opportunity cost stings.
Unfortunately, most of us are not setting up a Roth conversion, looking at the tax liability, and saying, “Hm, all right, I’ll just spend $600 less each month this year to offset that big tax bill!” It just becomes another expense that eats into money we would’ve invested.
So what’s a Rich Girl to do?
How willing are you to be strategic about how you use your investment accounts later in life?
This is where I reach the same conclusion that I reached in my most recent Roth/Traditional discussion.
The important thing is controlling how you draw down your own funds in retirement.
Remember how we talked many paragraphs ago about how a reader asked why she wouldn’t convert it now while the account is small instead of later when it’s big?
The fundamental flaw with that question is that it ignores the reality of how 401(k) conversions to Roth dollars actually happen later in life.
How Roth conversions and 401(k) withdrawals work in retirement
When you slap your two weeks’ notice on your boss’s desk and ride your hoverboard out of the office at the end of your career, you’re not going to look at your 401(k) that night and say, “All right, time to pay taxes on this million-dollar account! Full send!”
You’re going to – little by little – convert chunks of the account, pay the taxes, and use it as if it’s income.
For example:
You have $1M in this hypothetical 401(k) (er, Rollover IRA – you know what I mean!).
You need $50,000 to support your lifestyle.
You’d convert $50,000 to Roth (then withdraw it) and be taxed on it as if it’s your only income, as opposed to converting $50,000 to Roth now when you’re essentially stacking it on top of your current income and paying a hefty tax bill.
In conclusion
In order to retire at all, you’re going to need investments outside of your 401(k), because even the maximum contributions for 40 years won’t be sufficient on their own due to inflation (unless returns average 9% on their own, which isn’t something I’d want to stake my retirement on).
And if you’ve got investments elsewhere (like in a taxable account), you now have options about how you structure your withdrawals and conversions to save money on taxes.
It’s more or less mathematically impossible for someone to find themselves in a position where their 401(k) is “too big” if it’s the only account they plan to live on, because they won’t be able to safely withdraw the entire amount they need from it without depleting it too quickly. This makes the concern around “being in a higher tax bracket in retirement” very, very unlikely, barring an environment where there are sustained high returns and abnormally low inflation for decades.
Ultimately, if you’re in the 12% marginal bracket today and you’re talking about a 401(k) that’s got $3,000 in it, you can do whatever you want.
If you’re making $100,000 per year and you’ve got a $50,000 401(k) you’re rolling over, you couldn’t pay me to convert that sucker to Roth now.
Regardless of whether you’re doing a Traditional Rollover IRA or choosing to convert to Roth, Capitalize will do it for you
I can’t emphasize enough how much easier this free service makes 401(k) rollovers. They’ll do it all for you, and you can either tell them you’d like to keep your 401(k) in its pre-tax status or weigh your options and convert it to a Roth IRA. It’s up to you!