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A friend of mine advises me to roll my current 401k into a Roth and take the tax hit now. He thinks that tax rates will definately be greater when I plan on retiring 15 years from now. I plan on retiring on 75% of what I make now. Is this good advice?

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(Note that I am not an expert or a financial professional. I'm just some guy on the Internet and the following may contain inaccuracies. Do your own research before you take action. The IRS website has a wealth of information.)

Distinct advantages of Roth IRAs:

  • People who are currently earning less than their expected lifetime average (young people, partially employed people, etc.) are probably in the lowest tax bracket of their working life. This makes it a good time to put money in a Roth IRA. Later in life when a person earns more money, the immediate tax benefit of an IRA deduction is more likely to outweigh the future benefit of tax free withdrawals.

  • Roth contributions can be withdrawn at any time without penalty. That is an incredible amount of flexibility. Just remember that earnings generally cannot be withdrawn until you reach 65. And funds rolled over into a Roth IRA cannot be withdrawn for 5 years.

Consider the tax bracket that you would be in if you rolled your traditional IRA into a Roth IRA. Would it bump you into a higher bracket? What percentage of that IRA money would go towards paying taxes?

Now compare that to the tax bracket your retired self would be in if you didn't roll over to a Roth and you waited until retirement to make withdrawals. You expect to draw less than you earn now, so you will probably be in a lower tax bracket. Furthermore, some portion of that IRA income will probably be tax-free due to standard deductions and exceptions. Are future taxes going to be so much higher that you would end up paying more in taxes than if you rolled over to a Roth now? (hint: no one knows, but we can make guesses)

Of course, it doesn't have to be one or the other. You could even do something like wait until you stop working to roll some of your funds into a Roth.

  • Advantage: Since you won't be working you will probably be in a lower tax bracket. Thus you could end up paying less taxes on the conversion.
  • Disadvantage: You will have to wait 5 years before you can withdraw rolled-over funds from a Roth IRA. You'll have to draw your living expanses from your traditional IRA in the mean time.
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No. Blanket statements "you should do this" are rarely right for you.

First - You wrote "current 401(k)." A 401(k) at your current job usually can't be taken out for this purpose. So this may not even be an option.

Next - what is your Marginal Rate? You see, the conversion gets taxed on top of your current income. So a married-filing-joint making a taxable (after exemptions, deduction, etc) $70,000, may pay 10% of gross income in tax, yet he's darn close to a 25% marginal rate, so after the first $700 converted, the next $72K is taxed at 25% , and then more money is taxed at 28%.

Without knowing more specific details from you, I'd ask you to consider your current marginal rate, and marginal rate at retirement. Keep in mind, at retirement, you start at zero. The exemptions and deduction cancel out some income. Then you have a 10% rate for some money, then 15%, etc. But if you retire at 75% of current income, you will be in the same or lower bracket at retirement. Friends are good to buy you a beer, but rarely for financial advice. This friend could have cost you a lot in taxes. Buy him a beer and explain why.

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