How to Convert a Traditional 401(k) Into a Roth IRA

Timing

Since you’ll be on the hook for income taxes on the amount you roll over, the timing of your rollover can have a big impact on how big your tax hit is and how long your money will have to grow tax-free.

​It makes less financial sense, for example, to do a rollover in a year when your income is excessively high due to, say, a big bonus or sizable stock option payout. Why? The extra income could push you into a higher tax bracket, making the rollover less tax-efficient than it would be at lower income levels.

​Similarly, if you want to give your rollover dollars enough time to recoup the tax hit and take advantage of compounding, it makes little sense to do a Roth IRA conversion in your 70s or later — unless, of course, you don’t need the money and want to leave a tax-free Roth IRA to your heirs. Ogorek says a rollover makes most sense when the assets have at least an additional 10 years to grow before you need to tap them. ​

So what’s the sweet spot in terms of timing a Roth IRA rollover? There’s no perfect answer, but there are general principles to follow to keep more of your retirement savings and make your nest egg last longer.​

Consider doing the rollover in a year when your reported income is low, says Rob Williams, managing director of financial planning, retirement income and wealth management at Charles Schwab. A good time, therefore, could be the year after you retire, when you no longer have a paycheck coming in, or before you start taking Social Security or retirement withdrawals mandated by the IRS. Typically, those are times when you’re in a lower tax bracket, such as the 12 percent bracket, which for married couples filing jointly includes income between $22,000 and $89,449. (Income of $89,450 or more for married couples will be subject to tax rates between 22 percent and 37 percent.) Doing a rollover and staying in the lowest tax bracket possible is the goal. “The period a year or so after you leave work or take early retirement can be among the most advantageous times to at least think about a Roth IRA conversion,” Williams says. ​

Execute the rollover over a multiyear period

Ogorek says retirement savers must be aware of the “game show aspect” of a Roth conversion. Just as a contestant on The Price Is Right who wins a new car is responsible for the tax bill on that “extra” earned income the car’s value represents, so too is a retirement saver responsible for paying taxes on the 401(k) assets he or she rolls over into a Roth IRA. One way to reduce the hit is to make several conversions annually, rather than converting the whole thing at once.​

Let’s say you have $1 million in your 401(k). If you roll it into a Roth IRA all at once, you could saddle yourself with a massive tax bill — “in the area of $300,000,” says Ogorek. Ouch. That’s a big number.

​Forking over that much cash isn’t good for two reasons. First, if you’re lucky enough to have the money in the bank to cover the tax bill, you still have to fork over a massive six-figure payment to the IRS. Second, if you don’t have the cash available, you’ll have to pay the tax bill with your retirement account assets. And that’s a double whammy, because you’ll have less money and fewer shares moving to the Roth IRA, which reduces your portfolio’s future growth potential.

​To minimize your tax bill, one strategy is to convert that $1 million in your 401(k) to a Roth IRA over, say, a four-year period. “A system in which you periodically convert over a period of years can be very effective,” says Williams. The most tax-efficient way to execute this strategy is to figure out how much money you can roll over each year without pushing yourself into a higher tax bracket. The goal is to know what your tax bracket ceiling is and stay under it so you don’t owe more to Uncle Sam. “Convert just enough until you reach the top of a certain tax bracket, and then stop and repeat the next year,” Williams explains. “Do that over three or four years, and that way you’re only tapping the lower tax brackets. If you’re patient and have a tax-efficient distribution plan, doing Roth conversions over a period of years can be very impactful.”​

Take advantage of withdrawal rules

A big plus of Roth IRAs is they are not subject to IRS-mandated required minimum distributions (RMDs). In contrast, if you keep your money in a traditional 401(k), you’ll have to start taking withdrawals when you turn 72, or at age 73 if you turned 72 after Dec. 31, 2022. “That means Roth accounts give your money more time to compound in a tax-deferred account,” Ogorek says.​

Converting to a Roth IRA has other benefits. You may have more investment choices in the brokerage account that houses your Roth than you would in your company’s 401(k). You can also simplify your financial life by consolidating multiple retirement accounts into a single Roth IRA. The biggest negative with a Roth conversion, aside from the initial tax bill you’re responsible for, is that you can’t take a loan out on your money like you can with a 401(k).

​In order to take tax-free withdrawals from a Roth, you must be at least 59½ and have held the account for at least five years. Otherwise, you could owe taxes on your earnings and, possibly, a 10 percent early-withdrawal penalty, too. When all is said and done, the biggest benefit derived from a conversion to a Roth IRA is pretty simple: “You will not have to pay income taxes” ever again on assets in the Roth, Ogorek says.​