In a recent episode of her Women & Money podcast, Suze Orman took a firm stance on a complicated retirement strategy proposed by a listener.
A 56-year-old retiree, Gina, sought Orman's advice on rolling over $1.6 million from her pretax 401(k) into a Roth IRA over ten years without tapping into her liquid savings to cover taxes. Her company's benefits advisor had recommended a series of steps that seemed, on the surface, like a viable plan to avoid an immediate tax hit. Orman, however, didn't mince words in her response: “That's absolutely crazy.”
Don't Miss:
- Can you guess how many Americans successfully retire with $1,000,000 saved? The percentage may shock you.
- A billion-dollar investment strategy with minimums as low as $10 — you can become part of the next big real estate boom today.
Gina's approach, as advised by her company, involved rolling over $100,000 from her pretax 401(k) to a Roth 401(k) and then from her Roth 401(k) to a Roth IRA. To cover the taxes owed on the conversion, she planned to withdraw $40,000 from her 401(k) and have her company withhold 100% of that amount for taxes. If too much was withheld, she anticipated receiving a refund; if too little, she expected to owe a manageable amount.
See Also: I’m 62 Years Old And Have $1.2 Million Saved. Is This Enough to Retire Stress-Free?
The rationale behind this strategy may have been to minimize the upfront tax burden, but Orman quickly pointed out its fatal flaw: taxes. When converting funds from a pretax 401(k) to a Roth account, you move money from a tax-deferred status to one where taxes must be paid upfront. “That's not a rollover,” Orman emphasized, “that's a conversion … so guess what? My dear Gina, you owe taxes from that point in time.”
One key misconception in Gina's plan is the belief that she could somehow lessen the tax impact by moving funds between different retirement accounts. Orman clarified that this isn't possible: “Like, what have you avoided there?” Any conversion from a pretax 401(k) to a Roth IRA triggers a taxable event in the year the conversion takes place and no amount of shuffling between accounts can bypass that reality.
See Also: How do billionaires pay less in income tax than you? Tax deferring is their number one strategy.
Moreover, Orman warned that if Gina’s Roth IRA hadn't been open for at least five years, even funds from a Roth 401(k) could face taxes on earnings when withdrawn. This added complication makes Gina's plan unnecessary and potentially harmful regarding unexpected taxes.
So, what should Gina do instead?
According to Orman, Gina should start converting portions of the 401(k) directly into the Roth IRA and paying the taxes from savings. Orman advised converting smaller amounts each year – like the $100,000 Gina originally suggested – but stressed the importance of covering the tax liability using funds outside of the 401(k).
Trending: Studies show 50% of consumers think Financial Advisors cost much more than they do — to debunk this, this company provides matching for free and a complimentary first call with the matched advisor.
“If you don't want to use your liquid savings to pay taxes, don't do it at all,” Orman stated bluntly. There's no way around the tax hit when converting from a pretax account to a Roth. The only variable is how you choose to handle the payment.
Investopedia also recommends that when moving funds from a pretax account to a Roth account to pay the funds with savings rather than from their 401(k). If you don't, you could miss out on years of compounding and have to pay more than the original tax amount from the conversion.
Gina's situation serves as a reminder that even well-intentioned strategies can backfire when you don't understand tax laws. For retirees with large pretax retirement accounts, the appeal of Roth conversions is undeniable: tax-free growth and withdrawals in retirement. However, trying to outsmart the tax system can lead to costly mistakes.
Understanding the basics of how retirement accounts are taxed is an important step before making any major moves. Consider speaking with a financial advisor you trust and who can explain the pros and cons of moving funds between accounts.
Read Next:
- Many are using this retirement income calculator to check if they’re on pace — here’s a breakdown on how on what’s behind this formula.
- This billion-dollar fund has invested in the next big real estate boom, here's how you can join for $10.
© 2024 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.
Comments
Trade confidently with insights and alerts from analyst ratings, free reports and breaking news that affects the stocks you care about.
