In a recent episode of her Women & Money podcast, renowned financial expert Suze Orman tackled a complex retirement strategy presented by a listener named Gina. The query revolved around a staggering $1.6 million rollover from a pretax 401(k) into a Roth IRA. Gina, at 56 years old, aimed to avoid incurring immediate taxes as she navigated this significant financial transition. However, Orman’s straightforward and candid response brought clarity to a potentially costly misunderstanding.
Gina’s approach, advised by her company’s benefits consultant, involved transferring $100,000 from her pretax 401(k) to a Roth 401(k), followed by a shift to a Roth IRA. To manage the tax implications of this conversion, she planned to withdraw $40,000 from her 401(k), assuming her company would withhold all taxes. The rationale was to minimize upfront tax expenses and potentially receive a refund if too much was withheld.
However, Orman was unequivocal in her critique. “That’s absolutely crazy,” she stated emphatically, pointing out a critical flaw in Gina’s reasoning: the misconception surrounding tax obligations during conversions. When funds are transferred from a pretax retirement account to a Roth account, it constitutes a taxable event, meaning that taxes must be calculated and settled based on the amount converted in the year it happens. Orman stressed that this technique of ‘rolling over’ does not evade tax responsibilities; it’s a direct conversion subject to immediate taxation.
One major faux pas in Gina’s plan was her belief that moving money between types of accounts could somehow reduce her tax burden. Orman firmly dispelled this notion: “What have you avoided there?” she asked. Each conversion from a pretax account to a Roth triggers taxes owed, regardless of account shuffling, and no strategy can eliminate this reality.
Additionally, Orman highlighted a crucial time constraint regarding Roth IRAs. For any earnings withdrawn from Gina’s Roth IRA to be tax-free, her Roth account must be open for a minimum of five years. This requirement introduces an additional layer of complexity and potential tax liabilities if not properly understood, underscoring the risks of Gina’s proposed strategy.
So, what recommendation did Orman offer instead? She suggested that Gina should consider a more straightforward approach: converting a portion of her 401(k) directly into her Roth IRA, with an emphasis on utilizing her liquid savings to pay any taxes incurred. Orman recommended converting smaller amounts annually — similar to Gina’s original suggestion of $100,000 — but with the crucial stipulation of addressing tax liabilities with funds outside of retirement accounts.
“If you don’t want to use your liquid savings to pay taxes, don’t do it at all,” Orman bluntly advised, reiterating the need to accept the tax implications when conducting a conversion from a pretax account to a Roth. The decision simply comes down to how one manages the associated tax payment.
Investopedia supports Orman’s guidance, emphasizing that it’s generally more prudent to cover taxes from savings rather than drawing funds from a 401(k). Not only can this approach preserve years of investment compounding, but it can also prevent future tax burdens from escalating beyond original amounts due to withdrawn funds.
Through Gina’s situation, Orman effectively illustrates an important lesson about retirement planning: misinformed strategies can lead to unintentional financial pitfalls, especially when navigating tax obligations associated with retirement accounts. For many approaching retirement with substantial pretax savings, the appeal of Roth conversions — which offer tax-free growth and withdrawals — can be enticing. However, rushing into decisions without a clear understanding of tax implications can lead to costly mistakes.
As individuals contemplate moves between various retirement accounts, it is crucial to understand the underlying tax principles involved. Seeking guidance from a trusted financial advisor can provide clarity on the advantages and disadvantages of different strategies, ensuring that individuals are well-equipped to optimize their retirement funds while mitigating tax exposure.
By staying informed and cautiously navigating the complexities of retirement account conversions, retirees like Gina can make decisions that align with their financial wellness goals, ultimately paving the way for a secure and prosperous retirement.