IRS increases 401(k) contribution limits for 2026
The IRS will increase 401(k) and catch-up contribution limits for 2026, allowing workers to save up to $32,500 for retirement.
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A Roth conversion is the transfer of assets from a pre-tax retirement account, such as a traditional IRA or 401(k), to a Roth IRA. People pay income tax on the converted amount in the year they transfer it, but the money grows tax-free and withdrawals in retirement are also tax-free. Additionally, Roth accounts are not subject to required minimum distributions (RMDs) upon retirement and are not taxable to your heirs.
According to the Financial Industry Regulatory Authority (FINRA), income taxes can be a retiree’s biggest expense, so it’s natural for people with most of their retirement savings in traditional 401(k) or IRA accounts to consider moving to a Roth account. Roth IRAs didn’t exist until 1997, more than a decade after Gen Xers (born between 1965 and 1980) started working, so most of their savings are likely in traditional accounts. Conversions in the second quarter of 2024 increased 46% year over year across all age groups, according to data from investment firm Fidelity.
However, “everyone’s situation is nuanced, so a thorough analysis is required to understand the complete picture to determine whether a switch to Roth is right for you,” said Chris Barkel, investment advisor and president of AXIS Financial. “If you have two people in the same situation except for one variable, a transformation may be wise for one person and not for the other.”
Can I mathematically determine whether I should do a Roth conversion?
People typically compare their current marginal tax rate to their expected future marginal tax rate. “The rule of thumb is that if future tax rates are high, conversion is more desirable; if future tax rates are lower, conversion is less desirable,” investment management firm Vanguard said in a report.
Financial advisors say this is a good start, but Vanguard argues that this simple rule overlooks situations in which Roth conversions are advantageous even if expected future tax rates are lower. Instead, Vanguard promotes a “BETR” or break-even tax rate.
BETR is the future tax rate whether or not you convert. You can calculate it using Vanguard’s Roth BETR calculator.
How does BETR work?
Compare an individual’s expected future marginal tax rate to BETR to determine whether a Roth conversion is beneficial. “In some ways, the decision comes down to one number,” Vanguard said.
Vanguard says this is how it works:
- If the future tax rate is BETR, converting will make no difference
- If BETR is below, the conversion will further worsen the investor’s return.
- If you are above BETR, conversion is the better option
example: A person with $100,000 in a traditional IRA in the 35% marginal tax bracket can expect to see a 24% lower tax rate in retirement. The IRA is expected to triple to $300,000 over 20 years. Based solely on tax rates, the person skips the conversion in the hope that they will pay less tax when they withdraw later. With BETR, you’ll see a different story.
Without conversion, your balance after paying 24% tax on withdrawal, or $72,000, would be $228,000.
A Roth conversion costs $35,000 (35%) in prepaid taxes. Assume that if you had kept investing that $35,000, it would have doubled to $70,000 after taxes. The loss in growth reduces the balance after 20 years to $230,000.
That translates to $2,000 more, Vanguard said, despite the lower expected future tax rate of 24%.
(Vanguard used this equation: $300,000 * (1 – BETR) = $230,000 to find the BETR, which is 23.3%, which is lower than the expected future tax rate of 24%, so the person should convert.)
Is there anything I should consider when deciding on a Roth conversion?
BETR is “a good rule of thumb as a starting point, but it doesn’t get into the weeds of someone’s particular situation,” Berkel said.
People also need to look at “softer” considerations, he said. These can include savings in taxable accounts (such as brokerage accounts and money market accounts), pre-tax accounts (such as 401(k)s and IRAs), and tax-free accounts (such as Roth accounts and health savings accounts). Future sources of income, such as traditional pensions, tax-free military benefits, and Social Security, should also be considered.
“Then you also need to factor in your expenses, including how much you want to spend on retirement and traditional goals,” Berkel said. “Most people don’t realize that if they leave a large pre-tax IRA to their children, they may have to pay even more taxes. Some may not care about this, but others may want to be conscientious about the taxes their children pay.”
By law, most non-spouse IRA beneficiaries must distribute the account in full by December 31 of the 10th year after the original owner’s death. If the deceased person already took required minimum distributions (RMDs) before death, his or her heirs must continue to receive RMDs each year and drain the account by year 10.th year. Distributions are taxed as income.
Distributions from inherited Roth accounts are not taxed as long as the account has been open for at least five years.
Medora Lee is USA TODAY’s money, markets and personal finance reporter. Please contact mjlee@usatoday.com. Subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday.
