I'm 69 With $760k in a 401(k). Should I Convert 25% per Year to a Roth IRA to Avoid RMDs and Taxes?

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Converting 401(k) savings to a Roth IRA can free you from having to take mandatory withdrawals at age 73 and beyond. Because Roth withdrawals are tax-free, any voluntary withdrawals you take won't be subject to income taxes. However, Roth conversion comes with a significant current tax bill. So, whether a staggered conversion over the next four years is right for you depends on your tax circumstances, goals and more. Here are some things to think about. You should also think about sitting down with a financial advisor to discuss ways to make the most of your retirement savings.

If you save for retirement using a 401(k) or similar tax-deferred retirement plan, Required Minimum Distribution (RMD) rules mean you will have to start taking taxable annual withdrawals from your account starting at 73 if you are currently 69. If you have significant retirement income from other sources, this may push your post-retirement income so high that you move into a higher tax bracket.

One way to avoid this is to transfer tax-deferred account funds into a Roth IRA. This Roth conversion strategy can free you from RMDs and provide you with a source for tax-free withdrawals in retirement. It also can function as an estate planning tool since Roth IRAs can be preserved and inherited tax-free. The downside is that you have to pay taxes on converted funds as if they were ordinary income.

To spread the conversion tax bill out over several years, some retirement savers convert a portion of their tax-deferred funds each year. Among other benefits, this can help them stay in their desired tax bracket and avoid being charged at a higher rate.

A 69-year-old with $760,000 in a 401(k) could convert 25% of the balance each year for four years. In some cases, rather than converting a set percentage each year it may make sense to convert just enough to keep the taxpayer's income in the same or next-highest bracket. However, at age 69, it will be necessary to start taking RMDs in about four years, which indicates a larger conversion amount will be needed to empty the account.

Converting $190,000 annually still might not completely empty the account by the time RMD became mandatory at age 73, due to potential continued earnings on the remaining funds. Any money that was left in the 401(k) would still be subject to RMDs. However, it would significantly reduce the size of the required withdrawals.

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If no funds were converted, in four years the 401(k) balance would be approximately $996,205, assuming a 7% average annual return. Using the IRS RMD tables, this indicates that the first-year RMD would be about $37,593. If this saver had $70,000 in other taxable income, the resulting $107,593 in taxable income would put a single taxpayer in the 22% bracket and result in a tax bill of approximately $15,511.

If the entire 401(k) were converted, RMDs would not be required. Without the added income from the RMD, the bracket would not change but the tax bill would be $7,241. That is an increase of $8,270 in the retiree's annual income tax bill due to the taxable RMD income.

In order to avoid this higher tax bill in retirement, the saver pays taxes on converted funds now. Assuming current taxable income of $100,000, the added $190,000 in converted funds would make total taxable income $290,000. This would put the taxpayer in the 35% bracket and generate a tax bill of $66,764. That's about $52,923 more than the $13,841 the taxpayer would owe on $100,000 in taxable income without any conversion.

Over four years, the overall added tax bill for the conversion would come to $211,692. Dividing $211,692 by the $8,270 annual increase in retirement taxes due to RMDs suggests it could take more than 25 years of paying taxes on RMDs in retirement for the retiree to break even on this conversion. Then again, there are other factors to weigh, such as expected portfolio growth, estate planning techniques and more.

Remember, this example makes assumptions for a simplified example. Consider matching with a financial advisor if you’re interested in guidance for your circumstances.

Because converting funds increases income, it can impact other taxes that are based on income. This includes Social Security benefits, up to 85 percent of which may be subject to income tax. Higher income can also cause Medicare premiums to rise.

Conversion can also play a role in estate planning, because funds in a Roth can be handed down to beneficiaries tax-free. If a saver anticipates leaving all or much of a 401(k) to heirs, it may make more sense to consider a conversion.

Because of the many considerations and the long time-line necessary for these strategies to play out, it can be difficult to identify the best move. Most retirees won't be in a higher tax bracket in retirement if they replace 70% to 80% of their pre-retirement income. However, some high-earning aggressive savers may have higher income in retirement than while working. And changes in tax rates are always possible. A middle-of-the-road approach that converts a portion of a 401(k) account to a Roth IRA can boost future flexibility while limiting current tax costs.

You can use this free tool to match with a financial advisor if you have questions about whether a Roth conversion is right for your goals.

Converting funds from a 401(k) to a Roth IRA can provide tax-free retirement income while also avoiding RMDs. These conversions require paying taxes on converted funds, however, so it may not make sense unless a retiree expects to be in a higher tax bracket after retirement. Conversions can also impact current Social Security benefit taxation and Medicare premiums. Estate planning considerations may also come into play, as Roth accounts can be passed down tax-free.

Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

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