Can I convert my 401(k) to a Roth IRA to save on taxes?

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Q. I would like to begin converting my 401(k) into a Roth IRA. Do I have to have earned income to do so? I retired in 2014.
— Trying to reduce future taxation

A. It’s a good time for many to convert their retirement funds to a Roth IRA.

But converting a traditional 401(k) to a Roth IRA is a two-step process.

“First, you roll over the funds to a traditional IRA; then, you convert that IRA into a Roth IRA,” said Laurie Wolfe, a certified financial planner and certified public accountant with Lassus Wherley, a subsidiary of Peapack-Gladstone Bank, in New Providence.

She recommends you consult with your financial advisor who is aware of your total financial picture before making this decision. That’s because the decision has several ramifications, and you don’t want to do the conversion in error.

Wolfe said Roth IRAs have the benefit of growing on a tax-deferred basis and withdrawals are tax-free, if all criteria are met.

“You do not have to earn income to convert to a Roth IRA, but there are a number of things to consider when converting, especially if you are already retired,” she said.

When you convert retirement money that is in a 401(K) to a Roth IRA, you will pay income tax on those funds at ordinary income tax rates, Wolfe said.

If any of your contributions were made on an after-tax basis, however, those contributions will not be subject to tax, she said.

Other than in that instance, there is a cost to conversion.

“The question arises then about the length of time in which this cost can be recouped and begin to grow beyond that cost,” she said. “In other words, you need to consider whether your time horizon will allow for your funds to grow enough to cover the cost of conversion.”

The time horizon is determined by your life expectancy, she said.

Once converted and the tax is paid, your money will grow tax-free.

Wolfe said because you are already retired, you should consider whether you need your IRA money to live on. In this case, it may not be smart to convert to a Roth.

If you need that money to live on, you must also consider that distributions from a Roth can only be made tax-free after you have had the Roth for five years and you must be over the age of 59 1/2.

“Other things to consider are whether the conversion will put you in a higher tax bracket and whether the added income in that year will affect your Medicare premiums,” she said. “There are income-based surcharges on Medicare premiums. One way to manage these two consequences is to spread the cost of conversion over a few years.”

If you do decide to proceed with a conversion, the money to pay the taxes should not come out of your retirement savings, Wolfe said. If you have to use funds from a traditional non-Roth IRA in order to pay the taxes, this distribution will be taxable and will cost you more in taxes.

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This story was originally published on June 2, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.