Although everyone’s tax bracket is different from a standpoint, in which tax bracket does it make sense to start converting your 401(k) to a Roth 401(k) and pay taxes up front? For example, I’m 42 and my combined income is $560,000 between my wife and me, which puts us in the 35% federal tax bracket.
Together, we have $2.6 million in retirement savings ($2.5 million of which is in traditional 401(k)/403(b) accounts). Assuming we retire at age 67, does it make more sense to start converting $2.5 million into Roth accounts and incur the tax in the next five to 10 years compared to 25 years from now?
-Gary
You’re right about everyone’s tax situation being different. That’s why we can’t draw a line at a specific tax bracket and say, “This is the point where Roth conversions make sense!” However, we can say Roth conversions This makes sense if you are currently in a lower category than you expect to be Retirement. I’ll walk you through some points to consider as you consider whether or not you’re in this situation. This will help you determine in which tax bracket Roth conversions make sense for you.
If you need help with retirement planning, tax strategy, or a different area of your finances, consider talking to someone Financial advisor.
Tax brackets play an important role in determining whether you should convert your tax-deferred retirement savings to a Roth account.
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Since the analysis focuses on comparing current and future tax rates. You are currently in a high bracket based on current tax law. In itself, this suggests that Roth conversions are unlikely to make sense for you, but that’s not the whole story.
Fortunately, determine your current Tax bracket It is pretty straightforward since it is mostly a known value at any given time. For example, here, you know that your federal marginal bracket is 35%.
There are times when it may not be so simple, such as if your income varies greatly from year to year. If this is the case, I usually recommend waiting until later in the year to do the analysis. Simply put, there’s less guesswork involved in calculating your income in November than in January, so your estimate for the year will be more accurate.
As I mentioned, it’s also important to consider your state’s income tax rate if that applies to you.
This part is a little trickier and less certain, especially if you’re still several decades away from retirement. You will need to estimate your slice of the future against the backdrop of the uncertainty inherent in multi-decade planning. Your career, income and tax laws may change over time. You can’t be sure how your investments will perform (and therefore how much your retirement fund might grow). However, with reasonable assumptions, your analysis can still be useful.
One option is to consider what income you would want if you retired today. Next, simply think about what tax bracket your income would put you in based on current tax law. If this tax rate is higher than the current rate, a conversion makes more sense. Conversions make less sense if this rate is lower.
(Remember, if you need help analyzing your tax situation and planning for the future, consider this Contact a financial advisor to talk about it.)
As you go through this process, there are some specific points to keep in mind:
Tax laws may change. As of today, Tax Cuts and Jobs Act valid. However, the relevant portions are scheduled to expire in 2025. Specifically, the tax brackets and the standard deduction return to pre-2018 levels (adjusted for inflation). Congress could also pass new laws that would change everything over the next 25 years. The unfortunate truth is that you have to make some assumptions about what you think your future tax rates will be.
Are you planning to move in retirement? Some states do not have a state income tax. If you plan to retire, consider that state’s income tax rate when estimating your future rate.
Annual appointment. Unlike contributions, which you can generally make by the tax filing deadline, Roth conversions must be completed by December 31 to apply for a given year.
Focus on the marginal tax rate. Your marginal tax rate, not yours Effective rateThis is the appropriate rate to consider. This is the tax bracket your next taxable dollar will fall into.
(And if you need more help making informed decisions based on these considerations, consider this Work with a financial advisor.)
A couple in their early 40s are reviewing their retirement accounts and considering a series of Roth conversions.
In addition to the potential tax advantages of a Roth conversion, Roth accounts provide you with more control and flexibility in retirement.
For example, because Roth withdrawals are not taxable, they do not affect taxes on your Social Security benefits or… Medicare IRMAA surcharge. Also, there isn’t any Required minimum distributions (RMDs) associated with Roth accounts, which means you won’t be required to start taking withdrawals at a certain age. RMDs add to your taxable income and can push you into a higher marginal tax bracket.
Finally, Roth accounts have estate planning advantages because they pass to heirs tax-free.
Depending on how important these considerations are to you, they may skew your analysis somewhat. In other words, if you’re currently in the 35% tax bracket but estimate you’ll be in the 32% tax bracket in retirement, it’s worth considering whether that extra control and flexibility is worth the 3%. The trade-off will be worth it for some people but not for others. (If you need help finding financial advice, This free tool It can connect you with up to three financial advisors serving your area.)
To determine whether Roth conversions make sense for you — and in which tax bracket they are most impactful — start by determining your current tax rate. Next, estimate your future price based on the assumptions you’re comfortable with and compare it to what you’re currently paying. Roth conversions make most sense when your current marginal tax rate is lower than what you expect in retirement.
Transferring assets during a market downturn is one way to achieve this Reduce your tax liability on a Roth conversionThe taxable amount depends on the value of the asset at the time of transfer. When the market recovers, gains within the Roth account grow tax-free, increasing the benefits of the conversion.
A financial advisor can help you evaluate whether a Roth conversion is right for you, as well as when and how to perform the conversion. Find a financial advisor It doesn’t have to be difficult. Free SmartAsset tool Matches you with up to three vetted financial advisors who serve your area, and you can make a free introductory call with your Match Advisors to determine who you feel is a good fit for you. If you’re ready to find an advisor who can help you achieve your financial goals, Start now.
Keep an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations such as the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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