Achieving Tax Diversification in Retirement
Diversifying tax exposure is an often overlooked aspect of retirement planning. Many focus on saving for retirement; not many focus on structuring for tax diversification. But tax exposure can quickly drain the retirement savings you’ve worked so hard for. Consider Roth conversions to maximize your retirement savings.
What is a Roth 401k?
A Roth 401k gives the advantage of tax-free withdrawals. The account is funded by after-tax contributions which can then be withdrawn tax-free. During retirement, the Roth 401k can be a source of tax-free income.
What are Roth conversions?
Effective in 2013, the American Taxpayer Relief Act gave plan sponsors the ability to offer in-plan Roth conversions. In-plan Roth conversions convert pre-tax funds to Roth, within in the plan. Because of ATRA, participants can elect to convert some or all of their funds to Roth within the plan, whether or not the amount is currently distributable.
Roth conversions can be an effective part of a tax diversification strategy, but they do come with a tax bill. They cost an upfront tax break.
To determine if they are worth it for you, consider the following two factors:
- Time
The full benefit of Roth conversions is realized after the fund is allowed to grow for an extended period of time. Some experts recommend a period of 10 or more years. The longer the fund can grow tax-free, the greater the tax benefit.
This makes it ideal for a younger employee. Because time maximizes the benefit, this may not be an effective strategy if the participant is close to retirement.
- Income tax bracket
It is also important to consider both your current and future income tax bracket. When converting to a Roth, the amount is counted as income and tax is charged in the year of conversion. This may put you in a higher income tax bracket than at the time of distribution, minimizing the benefit of the Roth conversion. It may not be worth it if it puts you in a higher income tax bracket.
In order to maximize your retirement savings, consider taking advantage of the new option of Roth conversions. With tax-free withdrawals, the plan diversifies your tax burden. It may be an effective part of your retirement strategy.