I'm 65, Taking Social Security and Have $830,000 in a 401(k). Is It Too Late to Convert to a Roth IRA?

There is no age limit to Roth IRA conversions.

There is no age limit on Roth conversions, so you can transfer pre-tax savings into a Roth IRA regardless of your age or retirement status. As long as you have qualifying funds in a pre-tax portfolio, you can move them to an after-tax Roth account.

A financial advisor can help you make important decision surrounding your retirement accounts, like whether to do a Roth conversion. Connect with a fiduciary advisor today.

That doesn’t mean a conversion is always wise. For households in retirement, the benefits of a Roth conversion are often relatively minor compared with the costs of making this switch. For example, say that you’re 65, are taking Social Security and have $830,000 in your 401(k). Technically, you are perfectly free to do a Roth conversion. In practice, though, it may not do as much financial good as you expect.

What’s a Roth Conversion?

A retiree considers converting her 401(k) into a Roth IRA.

A Roth conversion refers to the process of transferring funds from a qualifying pre-tax retirement account, like a 401(k) or traditional IRA, to a Roth IRA. There’s an important caveat: the transfer requires you to pay income taxes on the money that you convert.

When you contribute to a pre-tax account, like your 401(k), you receive a full tax deduction for the amount that’s invested. Then, in retirement, you pay income taxes on all withdrawals (both returns and principal). But when you contribute to a Roth IRA, you get no tax benefits on the amount that’s invested. In return, qualified withdrawals can be made completely tax-free. Roth accounts also aren’t subject to required minimum distributions (RMDs) since the money has already been taxed.

The main advantage of a Roth IRA is that your portfolio grows entirely tax-free. If you invest $1,000 and it grows to $10,000 you only pay taxes on the $1,000 before it goes into your account. With a pre-tax portfolio, on the other hand, you have more capital to invest in the first place. Every dollar on which you don’t pay taxes is a dollar that can grow over time.

Consider speaking with a financial advisor if you need help managing your retirement savings or deciding between pre-tax and Roth accounts.

Tax Impact of a Roth Conversion

When you make a Roth conversion, every dollar that’s converted is added to your taxable income for the year. For people under 59 ½ years old, you’ll need another source of liquidity to pay those taxes. However, if you’re 59 ½ or older, you can pay those taxes with money from your portfolio. Just keep in mind that this will reduce the value of your portfolio and its potential for long-term growth.

For example, say you convert $830,000 from your 401(k) into a Roth IRA. Also imagine that your income matches the median U.S. household income of around $75,000. A lump-sum conversion would increase your marginal tax rate from 22% to 37% and leave you potentially paying hundreds of thousands in federal taxes. On the other hand, you would never pay taxes on that money again, giving you access to tax-free returns and withdrawals later in life.

Finally, all Roth conversions have a five-year cooldown period. This means that you must leave the funds and associated returns in place for five years after making the transfer. Luckily, if you need help doing a Roth conversion or navigating the tax rules of Roth IRAs, a financial advisor can be a valuable resource.

Roth Conversions in Retirement

A retiree enjoys a cup of coffee after doing some work on her finances.

Late-stage Roth conversions are a common question. Often, people ask whether they can move their retirement funds to a Roth account. That’s the wrong question. The real issue is, should they?

The rule of thumb is that a Roth portfolio is most useful when your current tax rate is lower than you expected tax rate in retirement. It’s also most useful when your portfolio has more time to grow, so that you can maximize the value of those untaxed returns.

By contrast, a pre-tax portfolio can be a better option if you’re currently paying higher taxes than you will in retirement. This allows you to defer your current (higher) taxes until later in life when you’ll pay a lower rate.

In our example, say that you’re 65 and have already begun collecting Social Security. If you aren’t fully retired, you likely will be soon. To make a conversion, you’ll have to spend a lot of tax money upfront, significantly reducing your portfolio’s long-term growth potential.

For example, say that you stagger your conversion over five years (converting $136,084 each year) to reduce of a lump-sum conversion. Let’s assume that you receive a mixed-asset return of 8% during that time. Here’s how it could play out:

Without Roth Conversion

• 401(k) value at 70: $1.23 million
• Portfolio income at 70 (using 4% rule): $49,500

With Annual Roth Conversions

• Roth value at 70: $800,000
• Portfolio income at 70 (using 4% rule): $32,000

Now, this example doesn’t account for your 401(k)’s growth during that five-year conversion, meaning you would have to do additional conversions to completely empty the pre-tax account. It also doesn’t factor in the taxes that would be owed on the pre-portfolio withdrawals . However, this example illustrates how Roth conversions at this stage in life have the potential to significantly reduce your after-tax income in retirement.

Of course, there are some cases where a late-in-life Roth conversion can be useful. Most notably, if managing RMDs is your most significant concern, you will accomplish that with a Roth conversion. You can pass a Roth IRA to your heirs tax free, and can use the portfolio as a source of short-term spending money without affecting your overall taxable income. But if you want to explore the possibility of a Roth conversion or other aspects of your income plan for retirement, consider speaking with a financial advisor.

Bottom Line

You’re never too old to legally complete a Roth conversion. You can do this at any time, as long as you have qualifying funds in a pre-tax retirement account. But the closer you are to retirement, the more likely it is that a Roth conversion will lose some of its luster.

Roth Conversion Tips

• Roth conversions may not always make sense, but that doesn’t mean they don’t have their place. Converting a traditional IRA or 401(k) into a Roth IRA can pay off in tax savings and significant tax-free growth over time. The challenge is figuring out what makes the most sense for you. Many people simply look at their current tax rate and compare it to their projected tax rate in retirement to determine whether or not to execute a Roth conversion. But Vanguard, the financial services giant, found that an investor’s individual “break-even tax rate” (BETR) can offer a better indication of whether a Roth conversion will be worth it.
• A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

Photo credit: ©iStock.com/Kameleon007, ©iStock.com/Luke Chan, ©iStock.com/FatCamera