Now’s a Great Time to Convert Your 401k to a Roth IRA

Stocks are still down for the year, which means a smaller tax bite for investors who do a conversion.

by Daniel Kurt

For anyone with money in a 401(k) account, watching the stock market this year has been a mostly gloomy exercise. But is it possible to actually use Wall Street’s mini-slump to your advantage? That’s precisely what some financial planners are suggesting. For workers who have money in their former employer’s retirement plan, converting all or some of those funds into a Roth IRA may help provide a little more financial freedom during retirement. And performing that conversion when stocks are off slightly from their pre-COVID highs means you’ll face a lower tax bill than you ordinarily would. Here’s what to know about converting your 401k to a Roth IRA.

Converting 401k into a Roth IRA: Potential Benefits

Most workers still have the lion’s share of their retirement money tucked inside a traditional 401(k). In part, that’s because nearly one-third of employers simply don’t offer a Roth option. And a lot of folks simply feel more comfortable with a this more “vanilla” investment choice. According to a 2019 survey by the Plan Sponsor Council of America, only 23 percent of employees who were offered a Roth version chose to go that route.

Those traditional 401(k)s certainly have their advantages. Workers kick in pre-tax dollars—often through a payroll deduction— and watch their money grow on a tax-deferred basis, thereby amplifying their potential gains. In retirement, they pay income tax on whatever they pull out.

But for a lot of workers who have separated from their employer, moving those 401(k) accounts into a Roth IRA provides an even bigger benefit, says Mark Pearson, founder of Nepsis Inc., a Minneapolis-based advisory firm. One drawback is that you have to pay income tax this year on the amount you convert, although a down market helps take away some of that sting.

Roth IRAs basically work in reverse from other tax-advantaged plans. You invest post-tax money now, but have the ability to withdraw the funds completely tax-free once you’ve owned the account for five years and reach age 59½. You don’t have to take requirement minimum distributions, or RMDs, at age 72 either, which gives you greater planning flexibility as you reach your later years.

For pretty much anyone who’s going to be in a higher tax bracket after they leave the workforce, Roths are the clear winner, says Pearson. That includes a lot of younger adults who haven’t reached their peak-earning years and find themselves in a relatively low tax bracket today.

Roth accounts also help you steer clear of unhappy surprises in retirement, since you don’t have to worry about triggering a huge tax bill when you make withdrawals.

“I would encourage investors who are putting money into their 401k to be thinking about the tax ramifications down the road,” he says.

Lastly, individuals with multiple investment sources often benefit from tax diversification by moving some of those funds to a Roth IRA. That way, you can pull just enough money from taxable accounts to stay in a low bracket, and rely on the Roth for the rest of your living expenses. “You really want to put yourself in a position where you have choices in where to take money from in retirement so you can manage your income tax bracket more efficiently,” says Pearson.

Tips for Converting Your 401(k) into a Roth IRA

Even if they wanted to, investors with larger 401(k) balances may not have the option of converting that entire amount in a given year, since doing so would create a substantial tax bill at year’s end. If you decide to roll over some of your pre-tax investments, select an amount that won’t put you in a cold sweat. “We highly recommend Roth conversions if it doesn’t put a burden on your cash flow,” says Pearson.

For those doing a partial conversion, prioritizing is key. Pearson recommends homing in on investments — that’s likely index or mutual funds for 401(k) holders — that have taken the largest short-term hit in valuation. Withdrawing those funds will result in a lower tax liability come April 15 of next year. Should those investments shoot back up again, you won’t have to worry about paying tax on those gains once you retire.

In addition, Pearson recommends choosing asset classes where you’re going to see the biggest tax benefits. That means focusing on growth-oriented stock funds rather than bond funds, which don’t have the same upside. Says Pearson: “What you’re trying to do is maximize your returns while minimizing the amount of tax you’re going to pay.”