Hey, everyone! I’m really excited about this week because I’ll be doing a Finance + Frugality theme all week here on the blog in honor of the brand-new Master Your Money Bundle that’s going to be available starting this Wednesday 3/27! If you’re interested in checking out one of the freebies (which will give you a taste of what’s available in the bundle), you can click here to sign up to be part of the free webinar–The Stress-Free Financial Blueprint— that will be happening TODAY (3/25) and 3/26, with 3 different times being offered. Whether you’re a seasoned personal finance nerd (like myself) or just wanting to get a better handle on your finances, there’s something in this bundle for EVERYONE. If you’re interested in signing up for the free webinar and seeing if the bundle would be a good fit for you, the window is closing soon, so sign up quick!
Our 401K to Roth Story
So last year, we did something that seemed kind of crazy to a lot of people—we willingly took a major tax hit to convert an old 401K of my husband’s over to a Roth IRA, which meant not only that we had to give up the hefty tax refund we would have gotten this year (which would have been around $8000! Yeah…), but that we also had to PAY some taxes when we filed for 2018.
Trust me, when I saw how much our refund WOULD have been, I may have slightly freaked out inside. Had we made a huge mistake?!
But let me back up a bit, to give you some context.
My husband’s current job (which he’s had for close to 5 years) does not offer any retirement benefits as of now, and when I quit teaching to stay at home with our kids back in 2016, we basically stopped contributing to retirement.
We knew it would take awhile to get our feet under us while we adjusted to living on just one income, but what we hadn’t anticipated at the time was that we would be purchasing a home in 2017, which hadn’t been in our plans AT ALL for that year. To shorten the story a bit, while we have been ITCHING to contribute to our retirement since we had to stop back in 2016, we were unable to do so until much more recently (like, in the past 6 months or so).
However, since my husband’s current employer doesn’t offer a retirement plan, we were left with only a couple options–
We could open up a new IRA and leave his old 401K exactly where it was. We could rollover his 401K into an IRA, which would require a bit more work on our part. Or we could be REALLY aggressive and rollover the entire thing (or part of the entire thing) into a Roth, which would require a tax hit.
After much discussion, we chose the third option.
First, A Quick Finance Lesson
Before I go on, I’ll just drop a refresher of a few different terms for you so that we’re all on the same page going forward.
As you probably know, there are several different kinds of retirement accounts you can open, each with its own benefits and drawbacks. In today’s post, I’m just going to talk about the three below.
- 401K Plan – An employer-sponsored plan, which an employee can usually contribute to using pre-tax dollars and which the company often offers a “match” on.
- Using pre-tax dollars means that whatever you contribute to your account in a year will take down the income that you will be taxed on for that year. So, if you earn $60K but invest $6000 of that in the year, you will only be taxed on the remaining $54K, thus lowering your taxes owed for that year.
- Also, most employers offer a “match” (sometimes as high as 10%) on the contribution that you put into the account. So, if you elect to have 3% of each paycheck put into your 401K and your employer offers a 3% match, you’re effectively investing 6% of your income into your retirement account.
- The money in 401K accounts grows tax-free until you elect to start making withdrawals from it, at which point you will be taxed on the amount you take out each year + any additional income you make during that year.
- Traditional Individual Retirement Account (IRA) – A retirement investment account that you open yourself, often because either your work does not offer a traditional retirement plan (like a 401K), or because you yourself do not work (but your spouse does) and you choose to open up a spousal IRA.
- Traditional IRAs offer tax-deferred growth, so you won’t owe any taxes upfront or while your money collects interest, but you will owe taxes when you withdraw.
- In most cases, traditional IRAs let you take a tax deduction each year that you contribute, just like a 401K would. So, if you invest $5000 in an IRA, you would be able to subtract that $5K from your amount of taxable income that year, lowering the amount you owe in taxes now.
- Roth IRA – A retirement investment account that you usually open yourself (though some employers offer Roth 401K versions), where the the invested amount can grow tax-free.
- With a Roth, you contribute money using after-tax dollars, meaning that you take a tax hit NOW, but then when it’s time to start making withdrawals, you don’t owe anything. (And if you were to pass away, the account would pass to your heir free of taxes, as well.)
A Quick Pros and Cons List
While we personally chose to convert our old 401K to a Roth IRA, that road may not be best for everyone. Here’s a quick pros and cons list for the different kinds of accounts (after which I’ll analyze why we chose to make the decision that we did).
- You don’t owe any taxes on it now and can actually use any contributions to LOWER the amount of taxes you pay now
- Employers often will offer a match, which is basically like free money
- Easy to set up and manage, as your employer has already made the decisions about who will manage the funds
- Can contribute up to $19,000 in a year if you’re under 50, or $25,000 if you’re over 50
- Can start taking withdrawals earlier than the usual 59-1/2 year mark without penalty, if you end up quitting/losing your job at age 55 or later
- All withdrawals are subject to tax, depending on how much you take out each year (and how much other income you bring in from other sources)
- You usually have no choice over who manages your accounts, which means that a hefty portion of your account might go to managing fees
- Often requires a “vesting” period before you can contribute or have access to the company-matched funds, which just means that you basically need to stay with that employer for a pre-determined length of time before they will A) let you contribute in the first place, or B) access the “matched” funds that they are making in your name. (Example: When I worked as a teacher, I had to work a minimum of 4 years in order to effectively own all the contributions they’d made in my name up to that point. Had I quit after 3 years, I would have forfeited all that money they’d contributed for me.)
- You can open one yourself without needing an employer who offers retirement benefits
- You get tax-deferred growth, which means that you won’t take any tax hits now (as long as you meet the requirements, which most people who go this route probably will), and you will also be able to lower the amount of taxes you owe for each year you contribute.
- If you don’t work but your spouse does, you can open up your own IRA and still make contributions to it yearly. (You each can contribute up to the individual maximum amount and take the full tax deduction of each.)
- You can choose who manages your account, which means that you can shop around and find a firm or adviser who offers low maintenance fees
- The most you can contribute yearly to ALL of your IRA’s (including Roths) is $6000 (which was just updated in 2019) if you’re under 50, and $7000 if you’re over 50.
- You owe taxes on any withdrawals made (how much will depend on the combined totals of ALL of your sources of income for that year)
- You can open one yourself without needing an employer to sponsor one for you, which means you can also choose who manages it for you (and look for a place that has low management fees)
- You get tax-free growth, which means that you don’t owe any taxes on the money you take out (as long as you withdraw within the penalty-free guidelines)
- Any heirs to your account will not owe any taxes on the money when it’s inherited
- If you are a qualifying first-time homebuyer or need additional funds for educational expenses, you can take a withdrawal from your Roth penalty-free
- There is no mandatory withdrawal schedule for a Roth (as opposed to the other two types, which require that you start withdrawing starting at age 70 1/2).
- The maximum amount you can contribute to ALL of your IRAs and Roth IRAs combined is just $6000 a year if you’re under 50, and $7000 if you’re over 50
- You owe taxes upfront on your income as per usual, and you can only make contributions to a Roth with after-tax dollars
- Any contributions to a Roth are not tax deductible, meaning that if you contribute the full $6000, you can’t lower the amount of your taxable income by $6K that year—you owe on the full amount
Why We Chose to Convert our Old 401K to a Roth
First of all, we needed to do a rollover of the old 401K into some kind of IRA anyway in order to start making retirement contributions again. We could have kept the 401K where it was indefinitely and opened up a new IRA to contribute to, but we wanted more control over the investment and the management of the account, and we also wanted more of a headstart on our Roth account.
To give you a sense for why we went the path we did, let’s do some quick calculations:
Let’s say we did a rollover of our initial $20,000 into a traditional IRA and then invested $6000 a year for the next 33 years (until we turned 65), and that our annual return was 8%.
$20,0000 + $6,000/year for 33 years, with an annual return of 8% (compounded annually) = $1,129,225.00
Of course, depending on what you invest your IRA in, the interest would probably be compounded more than just once annually, so let’s do a second calculation just for fun with the interest compounded daily:
$20,000 + $6,000/year for 33 years, with an annual rate of 8% (compounded daily) = $1,255,869
Note: Either a Traditional IRA or a Roth IRA is going to GROW tax-free, so they would both grow to that same amount if we made the same contributions every year.
Now the fun starts when it comes time to withdraw—
If we decided to withdraw $50,000 a year from a Traditional IRA, you would be in the 15% tax bracket and would owe $5,619 on the amount (not accounting for the standard deduction, but I’m also trying to account for the fact that some income on top of the $50K would also be coming in from other sources such as Social Security, so I’m just counting the $50K as being fully taxable).
Therefore, for every year we took a withdrawal out (which we anticipate would be every year until we died), we would owe that $5,619 on a $50K withdrawal, meaning we would be living off of the remaining $44,381 each year, rather than the full $50,000 amount we would be able to if we were withdrawing from a Roth.
So there’s obviously quite a lot of money that we’d save in the long run by converting that amount to a Roth now and not needing to owe any taxes on it down the road.
Let’s talk about the upfront costs of the conversion, though.
Technically when we filed for taxes for last year, we didn’t OWE $8000 in taxes—that’s just the refund we WOULD have gotten had we not converted this 401K to a Roth. Basically, when you convert a 401K or a Traditional IRA to a Roth, the amount is added toward your taxable income, so you can’t just plan on being taxed on the amount you roll over–you also need to account for the fact that it might push you into a higher income bracket or that you might lose certain tax benefits from being pushed up higher.
In our case, we not only owed taxes on the full amount we converted ($20,000), but we lost the Earned Income Tax Credit and also had to owe money back for our health insurance (since we have to get ours through the Health Marketplace because Matt’s employer doesn’t offer any). Therefore, when all was said and done, we got a minimal federal return back this year and then owed some money in state taxes, so we actually ended up breaking *almost* even between the two.
If you count the $8,000 we would have gotten in tax refunds as a “loss” this year, then we will essentially make up for that loss in less than two years when it comes time to withdraw in retirement. Of course, we’ll also be paying the taxes on the initial $6,000 we contribute each year for the next 33 years, which, if it’s still taxed at 15% (which it might go up, but for the sake of ease, we’ll keep it at 15%), would mean $29,700 in taxes over the next 33 years.
All told (if I’m doing my calculations as correctly as I can figure), we took an $8,000 hit now plus the $900 paid in taxes on our contributions for 33 years, which comes to $37,700.
BUT, if you calculate the amount of taxes we would have paid over 25 years of making withdrawals of $50K per year from the account, we would end up paying $140,475 in taxes in the long run.
So, why did we choose to lose an $8,000 tax refund this year?
Because we’re planning on it saving us over $100,000 in the long run 🙂
Should You Do the Same?
Now, just because you might be impressed with these figures DOESN’T mean that this is automatically the same thing you should do as well (or that you should start putting all your retirement contributions into a Roth rather than a 401K).
A couple things to consider.
- We are not offered any retirement plan by my husband’s employer, and as I am self-employed, we have to currently come up with all of our retirement funds ourselves.
- If you are offered a 401K or similar retirement plan through your employer that has a match, contribute the full amount up to the match. If you run the numbers, it’s worth it to get the free money now and owe taxes on the withdrawals later pretty much every time. Once you’re contributing the full amount up to your match, then it’s probably wise to contribute the next $6000 a year into a Roth. If you STILL are able to contribute more to retirement after those two things (go you!), then make sure to max out your 401K to the full $19,000.
- Be aware that whatever amount you convert will be added to your gross income for that year
- A conversion could push you into a higher tax bracket, so be prepared to have to pay more on your conversion amount than you’d maybe intended
- As for us, your new gross income for that year could have other effects on your taxes for that year, such as credits that you can take or are qualified for, or on your health insurance costs (if you go through the Marketplace)
- Note: You can choose to use funds from your converted IRA to cover your taxes—it just means you’ll have less to start with in the account. This could be an option for you if you don’t have the money in the bank to cover the tax hit come filing time.
- As we knew that we would take a tax hit, we decreased the number of exemptions on my husband’s paychecks so that more money would be taken out every month for taxes upfront.
- Normally, we would have gotten nearly all that extra money paid as taxes back in a typical tax year (if not all of it), but this year, we used every cent we’d paid upfront for taxes, plus the credits and such we’d qualified for because of our children and so on. So, if you’re thinking of making a conversion, calculate if you can afford to have more taken out in taxes on each paycheck to make it easier to save up the money you’ll need.
- We had about $5000 in savings that we could have dipped into had we needed to when tax time come.
- This will totally depend on how much you convert, but we knew that our $20K would probably not be taxed higher than 15% (because of where we anticipated the rest of our income being at), so we made sure we had at least the $3000 in savings beforehand.
- Many financial advisers and planners say that since you’ll likely be in a lower tax bracket in retirement than you are now, it’s not worth taking the tax hit now to save later.
- This totally depends on your situation. If you’re in too high of an income bracket (think: between $122K or $203K currently depending on your filing status), you don’t qualify to open up a Roth anyway, so the question might be moot for you.
- However, you need to calculate if it’s more worth it for you to save money upfront each year until retirement (by getting the tax deduction each year) than for you to save it upon retiring. Many calculators comparing the cost of a Traditional IRA vs. a Roth (such as this one) make it seem at first glance that Traditional IRAs are smarter in the long run. However, if you read the report, they are counting on you investing ALL of the money you saved upfront in tax deductions directly into retirement, which…most people probably would not do. (I know we wouldn’t!)
- A calculator I liked that compared your current tax rate with your future anticipated tax rate, as well as if a conversion might be a good choice is this one.
- It’s also worth noting that many people nowadays are making more than they anticipated during retirement, either due to having a part-time job, turning a hobby into a side hustle, earning passive income from things like renting out real estate, the amount of Social Security combined with their retirement withdrawals, etc. As we personally didn’t make very much last year for our situation as a family of 4, we knew that the tax hit upfront on the $20,000 would pay off huge in the long run since we’re in a lower tax bracket now anyway.
- However, if you happen to be flirting with the line between two tax brackets and can use any deduction you can get, it might be worth it for you to invest your money in a traditional tax-deferred account. I’m not a tax expert, so this would have to be something you’d figure out for yourself and your own annual budget and tax needs.
Hope you found this helpful, and if you want more ways to maximize your finances, from how to earn more to how to more effectively manage what you already have, make sure to check out that free webinar and then the Mastering Your Money Bundle once it’s available on Wednesday!
I’ll also be sending out an exclusive email this week to my email subscribers only that will have my own personal money philosophy as well as some of the financial resources (including a book list!) that I’ve found the most useful for me. If you’re not signed up for my email list yet, click here!
Note: I am not a certified financial expert, so before you make any major financial decisions, make sure to consult a professional.