401K to IRA to Roth

[Joeponcho]

Hello,

  I recently talked to a Financial Advisor that informed me that there's tax implications involved in Drawing from 401K's upon Retirement. He said that the idea is to convert 401K's to IRA's upon retirement then convert them to Roth's. I'm having a hard time wrapping my head around the tax implications and how that conversion lessens the blow. Could someone please explain this to me?

Thanks.

Joe

[PNWRambler]

Assuming your 401k is not a ROTH 401k... Moving your traditional 401k to a traditional IRA will have no difference on taxes.  But this allows you to convert from a traditional IRA to a ROTH IRA.  

When you pull money from a traditional 401k or IRA you will pay taxes at your current tax bracket with every withdrawl.  Say you're at 20% tax bracket, and you have a million in your traditional 401k or IRA.  You pull it all out, you pay $200,000 in taxes.  You pull out $100,000 and you'll pay $20,000 in taxes.  In a ROTH IRA, you have no taxes on anything.  They were paid before you ever deposited the money.

If you convert it to a ROTH IRA, you'll pay all the taxes now.  If you move $100,000 from a 401k to an IRA then to a ROTH IRA you'll have a $20,000 tax bill due today that you either pay in cash or pull from your principle.  

If you have the extra cash to pay the tax bill then there are some advantages to converting to ROTH earlier on.  It'll grow tax free until you need it, and there's no required minimum distributions with a ROTH IRA like with a 401k.  The younger you are, or the more wealth you have overall, the more it makes sense to convert to ROTH now. 

In addition, if you can put future contributions into a ROTH 401k instead of traditional 401k at work then I would do that.  

[Joeponcho]

Thanks PNW Rambler. So the best I can do at minimizing the tax hit is to convert the 401K's at the time of your lowest tax bracket, correct? Is there anything else I'm missing? The problem is I have over 1 million just in 401K's. That's aside of my pension.

[PNWRambler]

In a sense, yes. Let's say you're going to retire in 5 years and you'll be in a significantly lower tax bracket at that point, the taxes you pay while pulling small amounts out of your 401k to live on will be less overall. And the amount of tax free growth you'd get over the next 5 years isn't a big deal. So just leave it as-is.

If you've got 20 years to retirement and you can pay the $200,000 in taxes right now (or in sections, over the next couple years) then your million will continue to grow tax free, and if it's invested well it'll probably be 5 million by then, that you can pull out tax-free. And you won't have any required minimum distributions if you choose to live off your pension.

Generally I wouldn't recommend converting it and pulling the taxes from the principle, it's better to wait until you can pay the tax bill in cash up front. YMMV

[tacpoly]

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@Joeponcho wrote:

Hello,

  I recently talked to a Financial Advisor that informed me that there's tax implications involved in Drawing from 401K's upon Retirement. He said that the idea is to convert 401K's to IRA's upon retirement then convert them to Roth's. I'm having a hard time wrapping my head around the tax implications and how that conversion lessens the blow. Could someone please explain this to me?

Thanks.

Joe

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@Joeponcho   You should ask your financial advisor to explain the tax implications to you until you understand it, because it will address your particular situation. 

For example, what @PNWRambler wrote is generally correct, but he failed to say that if you take out money from your 401k, depending on the amount, it can move you to a higher income tax bracket, which would significantly increase your tax liability.  

Let's say you are currently in the 20% federal income tax bracket. You decide to move $1M from your 401k to a Roth IRA, you just put yourself in the top (37%) tax bracket.  So your tax bill won't be $200K, it will be $370K. 

What you should do is talk to your financial advisor as to what moves will optimize tax savings for your particular financial situation. 

[Joeponcho]

Thanks PNWRambler and tacpoly! That helps a lot! I spoke with my Advisor about so many things that I didn't really get the specifics of what meant by the "Tax Hit" at Retirement. It makes sense now that you guys explained it the way you did.

[Anonymous]

Yes, certainly don't act on advice from the internet!   Use a good advisor.   From what you are saying, it's not clear that your Financial Advisor is explaining things clearly enough.   Ask more questions and if that doesn't help, look around for another advisor.  (I go only for flat fee ones, where you pay by the hour and there is no asset management, but others have other preferences).

Just as a common example where things get unexpectedly complicated: IRMAA, which (of course!) is the Income-Related Monthly Adjustment Amount.   Once you reach 65, it's pretty likely that you will paying Medicare premiums every month.   However, if you show "too much" income, including withdrawals from non-Roth IRA/401(k) and from Roth conversions, you get charged a monthly surcharge that can be very expensive.  The kicker is that the determination of income is based on the return 2 years earlier, so things that go on your return filed when you are 63 can have important implicatons two years later.

A good advisor can help you navigate all this (e.g. sometimes taking the IRMAA hit is the right thing to do to reduce costs later)

[iced]

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@Joeponcho wrote:

Thanks PNW Rambler. So the best I can do at minimizing the tax hit is to convert the 401K's at the time of your lowest tax bracket, correct? Is there anything else I'm missing? The problem is I have over 1 million just in 401K's. That's aside of my pension.

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Not necessarily. It can also be more tax effective to roll a smaller balance, even if it's at a higher bracket, and let it compound and grow in a Roth. You also have to factor in what your tax bracket is today versus what you anticipate it to be in retirement (which itself is a bit speculative as we simply cannot know what the tax brackets will look like in the future).

As others have said, this is a question that will have a different answer for each and every individual case, so this can really only be answered by your FA. As for your original question, it's been more or less answered. You will pay taxes on 401k withdrawal one way or the other -- the question boils down to whether it makes more tax sense to do it now (to roll into a Roth) or to do it in increments throughout retirement.

This all also assumes this is a traditional 401k. If it's a Roth 401k (which it sounds like it is not), this is a moot issue. Likewise, if the 401k has after-tax funds in it, there's also ways to reduce the tax hit and roll it into a Roth. Another consideration is your current employment -- many 401ks do not permit rollovers or other certain activities against them while you remain employed with the plan's employer. Again, this is all information your FA should already have, and if they're not making your options understood, you either need to keep asking or get a new FA.

[MarkintheHV]

I did all this back in 2009 when my financial advisor told me that taxes will never go down and that was the best time to do it before upcoming tax increases

[Joeponcho]

Thank you for all the input. My FA has been explaining things, I just like to research the heck out of this stuff ahead. I guess I just don't want to end up later on thinking that I should have made changes now! I like my FA, he's with Fidelity which has been great for many years with me monitoring my own investments. Now it seems like I should let my FA help me manage our investments and strategize our best tax minimizing!