Roth conversions are a popular topic. Many are familiar with the basic concept – moving money from a traditional, tax-deferred retirement account like a Traditional IRA or a 401(k) into a Roth IRA. The key difference between accounts is how they are taxed. Traditional accounts give you a tax break upfront, but withdrawals in retirement are taxed as ordinary income. Roth accounts flip that: you pay taxes now, but qualified withdrawals later are tax-free. When you convert, the IRS treats the amount you move as taxable income in that year, and you can convert as much as you like as often as you like.
The main idea behind a Roth conversion is to pay taxes at a known rate today in exchange for potentially avoiding higher taxes in the future. For example, if you believe your tax rate in retirement will be higher due to higher income, tax law changes, or required minimum distributions (RMDs), then it can make sense to convert some funds now while your tax bracket is lower. Once the money is in a Roth IRA, it grows tax-free, and you’re not subject to RMDs during your lifetime, which gives you more flexibility in retirement planning.
One of the most important factors when contemplating a Roth conversion is timing. It often makes the most sense during years when your income is unusually low. In these lower-income years, you might want to convert just enough to keep you from spilling into a higher tax bracket. This strategy allows you to gradually shift funds into a Roth at a relatively low tax cost. If you are age 65 and older you should also keep in mind Income Related Monthly Adjustment Amount (IRMAA), a surcharge added to Medicare Part B and Part D for higher-income beneficiaries.
Age is relative as well. The longer your life expectancy the more appealing a Roth conversion may be because you have more time to allow for the compounding tax free growth to offset the upfront tax hit. You need time to recoup these upfront taxes.
Another factor to consider is how you will pay for the taxes when converting. It is recommended to use outside funds, preferably cash. The reason is so 100% of your conversion moves into the Roth.
In summary, a Roth conversion can be a fantastic financial planning strategy. However, it does not make sense for everyone. It’s important to weigh the pros and cons such as tax implications, timing, and current income versus future estimated income. It’s recommended to analyze your entire financial picture; a Roth conversion is just one piece of the puzzle. Understanding how a conversion impacts your overall financial plan is critical.
Brian Stone
Director
Disclosures:
This is provided for informational purposes only and should not be interpreted in any way as investment, tax, accounting, legal or regulatory advice. An investor must take into consideration his/her individual circumstances.
There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. All expressions of opinion are subject to change. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their wealth advisor prior to making any investment decision.
