Ask an Advisor: We're in the 35% Tax Bracket. At What Point Does It Make Sense to Start Converting Our 401(k) Into a Roth?

Although everyone is different from a tax bracket standpoint, at what tax bracket does it makes sense to start converting your 401(k) into a Roth 401(k) and pay the taxes upfront? For instance, I am 42 with a combined income of $560,000 between myself and my wife, putting us in the 35% federal tax bracket.

Combined 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 converting the $2.5 million into Roth accounts and take the tax hit 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, "Here's the point where Roth conversions make sense!" However, we can say Roth conversions make sense if you are currently in a lower bracket than you expect to be in retirement . I'll walk you through some of the points to consider as you think about whether you're in that situation or not. This will help you determine the tax bracket at 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 .

Your Current Tax Bracket vs. Future Tax Bracket

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

Your Current Tax Bracket

Fortunately, determining your current tax bracket is pretty straightforward since it is mostly a known value at any given point in time. For example, here, you know your marginal federal bracket is 35%.

There are times when it may not be so straightforward, like if your income varies considerably from year to year. If that's the situation, I usually recommend waiting until later in the year to do your analysis. There's simply less guesswork involved with calculating your income in November than there is in January, so your estimate for the year will be more accurate.

As you point out, it's also important to consider your state income tax rate if that applies to you.

Your Future Tax Bracket

This part is a little trickier and less certain, particularly if you're still several decades away from retirement. You'll need to estimate your future bracket against the backdrop of uncertainty that is inherent with multi-decade planning. Your career, income and tax laws may change over time. You can't be certain how your investments will perform (and therefore how large your retirement nest egg might grow). However, with reasonable assumptions your analysis can still be helpful.

One option is to consider the income you'd want if you retired today. Then, simply consider the tax bracket that income would place you in based on the current tax code. If that tax rate is higher than your current rate, a conversion makes more sense. Conversions make less sense if that rate is lower.

(Remember, if you need help analyzing your tax situation and planning for the future, consider connecting with a financial advisor to talk it over.)

Specific Factors to Consider

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

• Tax laws may change. As of today, the Tax Cuts and Jobs Act is in effect. However, relevant portions are scheduled to sunset in 2025. Namely, tax brackets and the standard deduction revert 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 you must make some assumption about what you think future tax rates will be.
• Do you plan to move in retirement? Some states don't have a state income tax. If you plan to move in retirement, consider that state’s income tax rate when estimating your future rate.
• All income is not taxed the same. For retirement, consider that Social Security receives preferential tax treatment , and at most, only 85% of your benefit is included in your taxable income.
• Annual deadline. Unlike contributions, which you can generally make by your tax filing deadline, Roth conversions must be completed by December 31 to apply for a given year.
• Focus on your marginal tax rate . Your marginal tax rate, rather than your effective rate , is the relevant rate to consider. That's the tax bracket that your next taxable dollar will fall into.

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

Roth Conversions Provide More Control

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

For example, since Roth withdrawals aren't taxable, they don't affect taxes on your Social Security benefits or Medicare IRMAA surcharges . Also, there aren’t any required minimum distributions (RMDs) associated with Roth accounts, meaning you won’t be required to start making withdrawals at a certain age. RMDs add to your taxable income and can potentially push you into a higher marginal tax bracket.

Lastly, Roth accounts have estate planning benefits, because they pass to heirs tax-free.

Depending on how important these considerations are to you, they may tilt your analysis some. In other words, if you're currently in a 35% bracket but estimate you'll be in the 32% tax bracket in retirement, it's worth considering if that extra control and flexibility is worth the 3%. The tradeoff 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 who serve your area.)

Bottom Line

To determine whether Roth conversions make sense for you – and at what tax bracket they’re most impactful – start by identifying your current tax rate. Then, estimate your future rate based on the assumptions you’re comfortable with and compare it to what you currently pay. Roth conversions make the most sense when your current marginal tax rate is lower than what you expect it to be in retirement.

Roth Conversion Tips

• Converting assets during a market downturn is one of the ways to reduce your tax liability on a Roth conversion , as the taxable amount is based on the asset's value at the time of conversion. When the market recovers, the gains inside the Roth account grow tax-free, maximizing the benefits of the conversion.
• A financial advisor can help you assess whether a Roth conversion is right for you, as well as when and how to execute the conversion. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff 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 .
• Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP .

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