Does it make sense to start converting our 401(k) to a Roth when we’re in the 35% tax bracket?

While everyone is different from a tax bracket perspective, in which tax bracket does it make sense to start converting your 401(k) to a Roth 401(k) and paying taxes upfront? For example, I am 42 years old and have a combined income of $560,000 between me and my wife, which puts us in the 35% federal tax bracket.

All together, we have $2.6 million in retirement savings ($2.5 million of which is in traditional 401(k)/403(b) accounts). Assuming we both retire at age 67, does it make sense to start rolling the $2.5 million into Roth accounts and take the tax hit over the next five to 10 years versus 25 now?

– Gary

You are right that everyone’s tax situation is different. That’s why we can’t draw a line at a specific tax bracket and say, “This is where Roth conversions make sense!” However, we can say Roth conversions it makes sense if you are currently in a lower band than you expect retirement. I will explain some of the points to consider as you consider whether or not you are in this situation. This will help you determine the tax bracket in which Roth conversions make sense for you.

If you need help with retirement planning, tax strategy, or a different area of your finances, consider speaking with a financial advisor.

Tax brackets play an important role when converting tax-deferred retirement savings into a Roth account.

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Since the analysis focuses on comparing your current and future tax rates. You are currently in a high bracket under the current tax code. By itself, this suggests that Roth conversions are less likely to make sense for you, but that’s not the whole story.

Fortunately, determining your current fiscal section is quite simple as it is mostly a known value at any given time. For example, here, you know your federal marginal group is 35%.

There are times when it might not be that simple, like if your income varies considerably from year to year. If this is the situation, I usually recommend waiting until the end of the year to do your analysis. There’s simply less guesswork involved in calculating your income in November than in January, so your estimate for the year will be more accurate.

As you point out, it’s also important to consider the state income tax rate if this applies to you.

This part is a little trickier and less certain, especially if you’re still several decades away from retirement. You will have to estimate your future period against the backdrop of uncertainty that is 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 big your retirement nest egg can grow). However, with reasonable assumptions, your analysis can still be useful.

One option is to consider the income you would want if you retired today. Then just consider the tax bracket your income would fall into based on your current tax code. If that tax rate is higher than your current tax 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 connect with a financial advisor to talk about it.)

As you go through the process, there are a few specific points to keep in mind:

Tax laws may change. As of today, the Tax Cuts and Jobs Act is in effect. However, the relevant parts are scheduled to expire in 2025. That is, the tax brackets and standard deduction return to their pre-2018 levels (adjusted for inflation). Congress could also pass new laws that change everything over the next 25 years. An unfortunate reality is that you have to make some assumptions about what you think 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 move in retirement, consider that state’s income tax rate when estimating your future rate.
Not all income is taxed equally. For retirement, keep this in mind Social Security receives preferential tax treatmentand at most, only 85% of your profit is included in your taxable income.
Annual term. Unlike contributions, which you can generally make before the tax filing deadline, Roth conversions must be completed by December 31 to claim for a given year.
Focus on your marginal tax rate. Your marginal tax rate, rather than yours effective rateis the relevant rate to consider. This is the tax bracket in which your next taxable dollar will fall.

(And if you need more help making informed decisions based on these considerations, take note working with a financial advisor.)

A couple in their 40s reviews their retirement accounts and considers a series of Roth conversions.

Beyond the potential tax benefits of a Roth conversion, Roth accounts give you more control and flexibility in retirement.

For example, because Roth withdrawals are tax-free, they don’t affect taxes on your Social Security benefits or Medicare IRMAA surcharges. Besides, there isn’t any minimum distributions required (RMDs) associated with Roth accounts, meaning you won’t be required to start making withdrawals at a certain age. RMDs are added 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 a bit. In other words, if you’re currently in the 35% 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 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 have the most impact, start by identifying your current tax rate. Then calculate your future rate based on assumptions you’re comfortable with and compare it to what you’re currently paying. Roth conversions make the most sense when your current marginal tax rate is lower than what you expect it to be in retirement.

Converting assets during a market downturn is one way to do this reduce your tax liability in a Roth conversionsince the taxable base is based on the value of the asset at the time of conversion. When the market recovers, the earnings inside the Roth account grow tax-free, maximizing 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 execute it. Find a financial advisor it doesn’t have to be difficult. The free SmartAsset tool matches you with up to three verified financial advisors that serve your area, and you can have a free introductory call with your advisors to decide which one you think is right 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 have unexpected expenses. An emergency fund should be liquid, in an account that is not at risk of major 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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