If you are like many people, the majority of the money you’ve set aside for retirement is held in your workplace savings plan, such as a 401(k) or 403(b). When the time comes to draw income from this portion of your nest egg, most or all of the distributions from your plan will likely be subject to income tax.
There is a growing appreciation for the idea of “tax diversification” in retirement. That means having access to income sources that are subject to different tax treatment. A good tax-diversification strategy includes a “tax-free” category of assets. A Roth IRA, for example, allows money contributed after tax to grow and receive qualified withdrawals tax-free.
You are now allowed to make a direct rollover of assets in a workplace plan to a Roth IRA, provided you are eligible to move the money in the first place. You can move money from a workplace plan when you separate from service (either retire or leave the employer), or in the event of death or disability. Depending on your retirement plan, you may also be eligible for so-called “in-service distributions,” allowing you to roll some of your retirement savings out of a plan and into an IRA before you leave your job. As with any rollover from an employer-sponsored plan, the money must move directly from the current plan to the administrator of the account (IRA or other employer’s plan) you are moving it to if you want to avoid unnecessary taxes or penalties.
Pay taxes now or later
The big question you should ask yourself before converting money to a Roth IRA is whether the benefit of tax-free income later in life is worth the cost of paying taxes now on the converted amount, which is required. All pre-tax contributions and earnings accumulated in your workplace plan that are converted to a Roth IRA are subject to current tax at your ordinary income tax rate(s).
Note that not all of the money needs to be converted at one time. To limit current tax liability when executing a direct rollover and conversion to a Roth IRA, you can choose to move just a portion out of the 401(k) and into the Roth in a given year. You should be aware that if the conversion drives your total income to certain levels, higher tax rates might apply and make the conversion more costly.
When it makes sense
Converting workplace plan dollars to a Roth IRA may be most worthwhile if you:
• Expect to be in a similar or higher tax bracket later in life when you need to make withdrawals
• Can pay the current tax liability on the converted amount from other available resources without drawing down your retirement savings
• Want to reduce your exposure to Required Minimum Distributions later in life. Distributions are required to begin after you reach age 70-1/2 from your workplace plan or traditional IRA. Distributions are never required from Roth IRAs during your lifetime, so you can maximize the tax advantages by keeping money in the account.
• Are trying to create more flexibility to manage your tax liability in retirement by owning a mix of assets subject to different tax treatment
Holding off on a Roth conversion
While the potential of future tax-free income makes a Roth conversion worth considering, it may not always work to your advantage. Situations where you may want to avoid such a conversion include:
• If you own company stock in your workplace plan. There is the potential to take advantage of special tax treatment of these assets when you take a lump-sum distribution, move employer securities out of the plan and take direct control of the assets (referred to as Net Unrealized Appreciation rules). Work with your tax adviser to be sure you meet requirements.
• If you expect your tax bracket in retirement will be lower than it is today. Then the cost of converting assets and paying tax on the conversion at your current rate may actually cost you more money in the long run.
There are a number of factors that go into a Roth conversion decision. Be sure to explore all of your options with guidance from financial and tax professionals to be sure you are doing what’s best for your long-term financial future.
Brandon Miller, CFP and Joanne Jordan, CFP are financial consultants at Jordan Miller & Associates, A Private Wealth Advisory Practice of Ameriprise Financial Inc. in San Francisco, specializing in helping LGBT individuals and families plan and achieve their financial goals.
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