Does a Roth Conversion Really Save Taxes?

A couple just retired and wants to determine if converting 401K assets to a Roth will raise their living standard.

The Facts

Married couple, both age: 64
John's 401K savings: $540,000
Mary's 401K savings: $980,000

John and Mary's non-retirement savings: $800,000
John and Mary both intend to apply for Social Security benefits at age 70.

John and Mary want to know the impact on their finances—current and future—were John to convert part or all of his $540,000 401(k) retirement account to a Roth retirement account. A conversion means taking money out of the 401(k), paying taxes on the withdrawals, and then contributing the withdrawn funds to John's Roth.

The Base Plan

John leaves his assets in his 401K

John and Mary create a Base Plan, which assumes that John leaves all of his retirement savings in his 401K plan. According to this Base Plan, John and Marry can spend $128,528, adjusted for inflation, in each future year. This is their annual discretionary spending. It's above and beyond their fixed (required spending) on housing costs, taxes, and Medicare Part B premiums.

The What-If Plan

Converting $500,000 in 401K savings to a Roth

Next John and Mary run the program specifying that John converts $100,000 each year for five years to a Roth, $500,000 total. He does this by entering a "special withdraw" of $100,000 from age 65-69 from his 401(k) and an equal sized contribution to a Roth in the same years.

The conversion raises the couple's annual discretionary spending from $128,528 to $136,471. That's $7,943 more each year for the next 36 years through age 100. The present value of all future discretionary spending increases sums to $248,096. This increase in living standard costs them a few hours of paperwork and entails no extra risk.

How Does this Plan Work?

The potential gain from a Roth conversion involves taxes. Because they aren't working and haven't yet received their Social Security benefits or started their 401(k) withdrawals, John and Mary have relatively little taxable income in the present compared to the future. The Roth conversion let's them take advantage of their temporarily low tax bracket by paying more taxes in the present and less in the future since withdrawals from Roth accounts are not subject to taxation. Of course, John and Mary need to have enough money to pay the extra taxes. That's where their $800,000 in non-retirement assets comes in handy.

The table below compares combined federal and state taxes in 2019 and for several years after the 2019 conversion.

The chart below compares lifetime taxes in the Base Plan and under the $500,000 conversion. Notice the long-term reduction in taxes in the Roth conversion scenario vs. the base plan.

The Bottom Line

Converting qualified 401(k) assets to a Roth can be a risk- and cost-free way to raise your annual discretionary spending.

No two Roth conversions are alike because no two lifetime personal economies are alike. Sometimes the savings are dramatic and sometimes modest—and sometimes converting to a Roth is a bad idea. Each household economy is unique. Fortunately, MaxiFi lets you experiment with different conversion options, and its calculations are customized to your household's circumstances and will show you precisely, to the dollar, what a Roth conversion will mean for your household's bottom line—its discretionary spending going forward.