Converting your 401(k) to a Roth portfolio will allow you to entirely avoid RMDs. This is a legitimate form of tax planning. However, often there’s a difference between whether you can do something and whether you should; whether it’s allowed, and whether it’s in your long-term best interest.
For example, say that you’re 62 years old. You have $1.6 million in a 401(k). If you convert this portfolio to a Roth IRA 10% at a time, you can avoid required minimum distributions on your $1.6 million. However, particularly for households approaching retirement, a Roth conversion may result in a net-loss. There’s a chance that the tax costs of making those conversions will outweigh the tax benefits of avoiding minimum distributions.
Here are some things to consider. Also consider matching with a fiduciary financial advisor who can help you weigh your options.
Starting at age 73 (or 75 starting in 2023), the IRS requires you to begin taking regular, minimum withdrawals from every pre-tax retirement account. This includes 401(k) and traditional IRA portfolios. These withdrawals are known as RMDs.
The exact amount you must take is based on the portfolio’s total value on January 1 and your age. You have until the end of each year to make the withdrawal, so you can take your minimum distribution in any amount at any time by or before December 31. If you don’t take your minimum distribution, the IRS charges a tax penalty typically worth 25% of the amount not withdrawn.
Like all withdrawals, you will have to pay ordinary income taxes on your minimum distributions. This can create a problem if you need less money than your minimum distribution, such as if you have other sources of income or multiple retirement accounts. In that case, you might prefer to leave the money in place for tax-free growth rather than pay income taxes on an unnecessary distribution.
One solution to this is converting your pre-tax portfolio to a post-tax Roth account, because the IRS does not require minimum distributions on Roth IRAs.
A Roth conversion is when you move money from a pre-tax retirement account, such as a 401(k), to a post-tax Roth IRA.
Mechanically, the process is typically simple. You open a Roth IRA with a qualified brokerage. Then, you can instruct your plan manager to transfer the assets from your pre-tax portfolio to the Roth IRA, or you can withdraw the money and assets personally and deposit them in the new account. If you move the money personally, you have 60 days to deposit it into the Roth portfolio.
