Contributions to retirement savings are one of the best ways to control how much tax you pay over your lifetime. The tax deductions of traditional options, like 401(k)s and traditional IRAs, save a significant amount of tax in your high earning years, but what do you do when your income falls? It could be time for a Roth conversion.
Converting to a Roth is as simple as moving money from a tax-deferred account into a Roth account. Should you consider taking advantage of this opportunity, or are you better off sticking to traditional retirement accounts? Here are some things to consider.
What Is a Roth Conversion?
All you need to do to convert a traditional IRA is to move some (or all) of its assets into a Roth IRA.1 You pay tax on the converted amount, but here’s the benefit: at least some of a traditional IRA holds pre-tax dollars, so the distributions you take from it in retirement are taxable income, in whole or in part. But a Roth IRA is created using after-tax dollars, so the distributions you take from a Roth IRA account in retirement are tax-free, no matter how large the growth.
Additionally, your Roth IRAs are not subject to Required Minimum Distributions, so you can continue to save and grow tax-free dollars for the remainder of your life. (Your beneficiary could be subject to different rules when they inherit your Roth IRA from you.)
Considerations Before a Roth Conversion
While a Roth conversion could be an excellent option for some, it could be a costly mistake for others. We’ve outlined four critical elements to consider before converting your traditional IRA into a Roth account.
Element #1: Your Future Tax Bracket
One of the main reasons for a Roth conversion is for the advantage of tax-free distributions in retirement. But will your tax bracket will be higher or lower in the future when you expect to distribute the funds? If you are still working and believe you’ll be in a lower tax bracket in retirement, it may be worth waiting to distribute assets then instead of converting now. On the other hand, if you’ve experienced a reduction in income (perhaps from a job loss, a missed bonus, etc.), you may be in a lower tax bracket now than when you will be in retirement. Conversions can also be a great option for people early in retirement who anticipate higher income once they start receiving Required Minimum Distributions.
When we plan for Roth conversions, we plan to even out your tax brackets throughout your life. If you’re in the 0% tax bracket in some years, it can mean you’ll pay (or have paid) more tax than you might have had to in other years.
Element #2: Tax Obligations
Your intention may be to create tax-free income in retirement, but in return, you will have to pay tax on that income at the time of the Roth conversion. The amount converted is additional taxable income, which could very well push you up into a higher tax bracket. While it’s possible to cover the difference using a portion of the distribution itself for withholding, this is typically not the best idea: you’d be robbing your future retirement of income, and if you’re not yet 59½, you’ll likely be subject to a 10% penalty on the amount withheld.
Element #3: Your Timeline to Retirement
If you’re already retired or are retiring soon, you need to be careful that you don’t convert money you will need soon. The money you convert into a Roth IRA must stay there for a five-year holding period, beginning January 1 of the year of the conversion. If you take a distribution before the five-year period has passed, you could be hit with a 10% penalty and/or additional income taxes. This does not mean you can’t use the strategy—in fact, early retirement is one of the best times to convert—just make sure you leave enough money in your other accounts for your first few years of retirement.
Element #4: How Much to Convert and When
Many people shouldn’t convert all of their tax deferred savings. Usually, the goal is to smooth out the changes in your tax, not to eliminate your tax in the future. By spreading the conversion across several years, you can lower your yearly tax obligation.
How to Make a Roth Conversion
Some 401(k)s and 403(b)s allow you to do a Roth conversion without moving your account to an IRA. Other times, you need to roll over some or all of an employer plan into an IRA first.
Being able to withdraw income tax-free in retirement makes a Roth an appealing option for many. While you may have chosen to open a traditional IRA years ago, you do have the option to convert it at any time. Before making any significant change to a retirement savings account, make sure to speak with your tax or financial advisor first. Together, you can review your unique financial situation and make the best decision.
As 2020 draws to a close, examine your tax situation and decide if this could be a good year for a conversion. But don’t wait too long, as many custodians become swamped with last-minute conversion requests.
Be sure to check out our most recent video, How to maximize your charitable deductions.