Paying taxes on a converted old retirement account to a Roth IRA from a 401K loan from current employer?

Question

I have an old 403B plan, I am 47 years old and would like to convert part of it to a Roth. I would like to convert $100k to the Roth, but will then have to pay taxes on the conversion. Lets just say $25K in taxes on the 100K conversion. Can I just take a loan from my existing 401K plan (for $25K) to pay the taxes, and pay the loan back over time.

The 401k has a value of about $1.1M and the loan will take 2.1 years to pay off.

I realize I will lose the time in the market and potential gain on this 25K loan, but is this a terrible decision? I feel that the 18 years of growth then ultimate tax free income at retirement will be worth it. Am I way off on this or am I missing something?

Answer 1

A conversion to ROTH is a bet that your current marginal tax rate is less than what your future marginal tax rate will be at retirement. The $25K you pay in tax now is essentially a $25k opportunity cost from your 401(k). You're paying $25k to get $100k tax-free.

Let's say that the future growth of either account is 8%.

After 10 years, that $125k would have grown to $270K The $100k would have grown to 216K.

So which is better - $270k that's taxable or $216k that's tax-free? It depends on what the tax rate is. Not coincidentally, the tax rate that makes this a break-even proposition is 25%. If the tax rates are lower in the future, then the taxable account has a better after-tax worth. If they're higher, then the tax-free account is better.

So it's not a terrible decision, but it only makes sense if you're in an relatively low tax bracket right now.

The loan just changes the timing of the cash flow, but at a high-level you're not creating any real value, just changing when money moves around, which isn't a significant change.