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What is the most tax efficient way of converting a pretax 401(k) to a Roth 401(k)?

I’m 55 years old and retiring at age 62. I have an $800,000 pretax 401(k) that I need to convert to Roth 401(k) before I turn 70 years old and RMDs become due. What is the most efficient way of doing this and minimizing taxes?

Retirement, 401(k), IRAs, Taxes
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It's great that you are thinking about beginning to move your traditional 401(k) balance to Roth balances so far in advance. I'll address tax efficient converting later, but first I want to make sure you actually accomplish your goal of avoiding Required Minimum Distributions (RMDs). Unfortunately, moving the money to a Roth 401(k) won't help for your goal because RMDs are still required on the 401(k) version of the Roth. As a result, you will need to get the money into a Roth IRA before you turn 70 1/2. There are two ways to accomplish this goal.

First, you can roll the 401(k) to a traditional IRA and then do the conversion to a Roth IRA. Your 401(k) plan documents will determine if this is possible to do before you retire at age 62, as not all 401(k) plans allow in-service distributions. A second option is to move the money to a Roth 401(k) and then roll it over to the Roth IRA. Again, your 401(k) plan may limit your ability to do this depending on if they have a 401(k) option or if they allow in-plan conversions.

For either strategy, you will be limited by what your employer's 401(k) plan allows in the plan documents. 401(k) plans are largely governed by the plan documents, which were drafted by your company and may not allow every option allowed by law. You will need to ask your human resources department for the rules regarding your 401(k), if it allows in-service distributions, if it offers a Roth version, and if conversions to the Roth portion are allowed. You should also get a copy of the 401(k) plan documents to confirm this yourself, or have a financial adviser help. If not, you can explore if reducing 401(k) contributions from now until you retire and contributing to a Roth IRA is beneficial to at least create some Roth money before your retirement date.
 

Regarding converting in a tax-efficient manner, there is a bit of personal preferences, a bit of guesswork, and a lot of math involved in maximizing your tax efficient conversion options. Below is a broad overview of the considerations you will want to look at if you don't have a fee-only and fiduciary financial planner who is guiding you in the process.

For your personal preferences, you will need to determine what your goal for the money will be. Is this money you intend to use during retirement; or is it legacy money you plan to give to your children, grandchildren, or a charity. This will make a big difference in the aggressiveness and amount you transition from the traditional to the Roth account. You will also want to explore what tax bracket you will want to be in both now and in retirement. While math will help to determine what makes sense with tax brackets, personal preferences also play a roll. Another factor is how much of your retirement portfolio do you intend to use early in retirement when you are healthy enough to enjoy it, and how much you want to make available for late-in-life medical care.

The guesswork comes in with what your tax rates will look like in retirement. Not only may your income change over the course of retirement, but the tax law is likely to change over the course of your retirement as well. We know the Tax Cuts and Jobs Act individual tax rates will expire after 10 years; but it is a guess whether they will be extended, allowed to revert back to the old rates, or changed.

Then the math is where the real fun begins. First, you will want to look at your current tax liability to see how much 'income' you can generate through Roth conversions and still stay within each tax bracket. Then you will want to calculate how much is worth converting considering each tax bracket and your expected tax bracket in the future. These future bracket expectations will also change based on the changing future RMD requirements and other income sources. You should also consider the benefit of paying these taxes now at each tax rate verses allowing the money that would be used to pay taxes to continue growing and then paying the taxes at the expected tax rate in the future.

Finally, make sure to consider how the conversions and the RMDs could impact taxation and fees over the next seven years and throughout the decades of your retirement. Both conversions and RMDs can increase your taxes on other aspects of retirement such as additional Social Security taxes prior to retirement, loss of deductions or tax credits due to AGI phaseouts, income-based Medicare surcharges, and taxation on Social Security income in retirement. Finding the right balance between paying taxes now through conversions and paying them later during retirement is important when making this decision.

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