question on converting 401K to Roth IRA

[EliteZags]

I know the basics for converting old 401K's to Roth and how most will do it once they are earning less to reduce the tax impact,
but given that gains with the Roth IRA are not taxed, why wouldn't be advantageous to just take the tax hit as soon as able to convert then lock in tax free gains over a longer time horizon? vs leaving in 401K and being taxed on gains later when converting?

[Tigerpine]

If you invest identically in either your Roth or 401(k), you have the exact same marginal tax rate whenever you pull out the money and any fees for the conversion are ignored, there is no advantage either way.  If in addition to the previous conditions, the fees incurred are identical at the time of conversion, you're slightly better off to keep it in the 401(k).

This makes sense, because multiplication is transitive.

---------Case #1:  Immediate Roth IRA Conversion------------
A.  Do ROTH IRA Conversion Now, paying Tax rate (Tax)
(401k Start)*[1-(Tax)]=(ROTH_I Balance)

B.  Balance at Year (Yr) assuming an average Rate of Return of (ROR):
(Balance)_Yr=(ROTH_I Balance)*[1+(ROR)]^(Yr)

C.  In terms of the Starting Balance, this can be restated as the following via substitution
(ROTH_I Balance)_Yr=(401k Start)*[1-(Tax)]*[1+(ROR)]^(Yr)


---------Case #2:  Roth IRA Conversion at Year (Yr)------------
A.  401(k) Balance at Year (Yr), assuming a Rate of Return (ROR)
(401k)_Yr=(401k Start)*[1+(ROR)]^(Yr)

B.  Convert the lump sum at Year (Yr), paying Tax rate (Tax)
(ROTH _LBalance) = (401k)_Yr*[1-(Tax)]

C.  In terms of the Starting Balance, this can be restated as the following via substitution
(ROTH _LBalance) = (401k Start)*[1+(ROR)]^(Yr)*[1-(Tax)]

D.  Rearrange terms
(ROTH _LBalance) = (401k Start)*[1-(Tax)]*[1+(ROR)]^(Yr)


Note that Step C from Case 1 and Step D from Case 2 are identical. This is, (ROTH_I Balance)_Yr = (ROTH _LBalance)

In the case of identical fees paid regardless of when the conversion is made, the only change is when the fee is paid.  If the fee is paid today, that amount of money is lost earlier so therefore has less time to compound, all else being equal.

Of course the real world will never work out this way exactly, but it's good to keep in mind when thinking about Roth IRA conversions.

[seattlecyclone]

I know the basics for converting old 401K's to Roth and how most will do it once they are earning less to reduce the tax impact,
but given that gains with the Roth IRA are not taxed, why wouldn't be advantageous to just take the tax hit as soon as able to convert then lock in tax free gains over a longer time horizon? vs leaving in 401K and being taxed on gains later when converting?

Tax rates being equal, you keep the same amount after tax regardless of when you convert.

You could convert $X in tax bracket T this year. You pay $XT in taxes, moving $X(1 - T) into your Roth IRA. It grows by a factor of G by the time you withdraw, leaving you with $X(1 - T)G to spend.

Alternatively you could leave your $X in your 401(k) and withdraw directly from that account during retirement. You invest in the same fund you would have bought in the Roth, so it also would grow by a factor of G by the time you withdraw. You would pay $XGT in taxes when you withdraw, leaving you with (1 - T)$XG to spend.

While the tax amount $XGT from the later withdrawal scenario is greater than $XT from the early conversion scenario, you're comparing post-growth dollars to pre-growth dollars; apples and oranges. You're left with the same amount to spend either way.

The main reason to prefer to pay tax in one year or another is if you expect your tax rate T to change; pick the year with the lower rate.

Another factor that would affect the timing is for the Roth conversion ladder to get earlier penalty-free access to this cash. Convert earlier and you get to withdraw the converted amount sooner. Convert later and you get a higher amount to withdraw early.

[Tigerpine]

The key is to understand the variables.  Keeping all other variables equal:

If you can get a better Rate of Return (after all management fees) at one place over the other, that choice with the higher Rate of Return is superior.

If you can take advantage of tax planning, do the conversion when your tax rate is lower.

This is where it becomes important to inform yourself of the investment options in your 401(k) vs. the investment options where you will hold the Roth IRA.  It is also important to learn about the tax code enough to make informed decisions about tax consequences.

Another thing to consider is RMDs (Required Minimum Distributions).  At age 72, the IRS requires you to take out a certain percentage from your 401(k) and tIRA.  That requirement does not apply to Roth IRAs.

Related, as I understand it, the money you take out of your Roth IRA is not included in income for purposes of determining your tax burden on Social Security benefits.  However, withdrawals from tIRAs and 401(k)'s (including RMDs), do count.  Therefore, your RMDs starting at age 72 could lead you to pay more in taxes on your Social Security benefits.

Note:  I am not a tax professional, but rather just a random guy on the internet who has an interest in taxes.  Please verify all information in this post before taking any actions.

[MustacheAndaHalf]

If your income drops in retirement, it could make more sense to have a Traditional IRA and pay less tax.  The money grows either way - although keep in mind your 401(k) is pre-tax, so a chunk of that money is owed to the IRS.  A benefit of the Roth IRA, in a tie, is removing the uncertainty of tax rates and "what you see is what you get".