Retirement planning: When does a Roth conversion make sense?
The end of the tax year gives some taxpayers the opportunity to convert retirement funds from a traditional IRA or 401(k) into a Roth IRA. Because so much hype surrounds Roth IRAs — which can offer significant tax savings for some investors — the decision can be complicated.
A traditional IRA or 401(k) is funded with “pretax” money. This money may have been withheld from your paycheck before taxes were computed, or you may have received a tax deduction on your IRA contribution. These contributions grow tax-free. When you take a withdrawal from your 401(k) or traditional IRA, you’ll pay taxes on both the money you put in and any gains you earned.
You fund a Roth IRA with money that has already been taxed. When you withdraw money from a Roth, you won’t pay taxes on either the amount you invested or the gains.
As with many financial matters, whether you benefit more from saving pre- or post-tax depends on your situation. Generally, if you’re working and paying a high tax rate, the immediate tax benefits of a traditional retirement plan outweigh the longer-term advantages of a Roth. You can invest more when you include your tax savings.
However, the lower your income, the lower your tax rate, which means you’ll save less by reducing your tax burden. You may also pay a higher tax rate in retirement than you do now. Younger workers generally benefit the most from Roth IRAs.
The benefits of a Roth conversion
When you perform a Roth conversion, you pay tax on the converted amount as if it were a withdrawal — but you won’t pay a penalty for taking the money out early (before age 59½).
The decision to do so is generally opportunistic. You might want to do it if your taxable income was unusually low this year, for example, if you were unemployed for all or most of the year, or you recently retired. Or maybe you have an unusually high number of tax deductions bringing your taxable income down.
In cases like these, you might be able to pay a tax rate of 0%, 10% or 15% on your converted funds. If you’d ordinarily be in the 25% or 28% tax bracket, this opportunity might be too good to pass up.
Remember that the amount you convert will be added to your income. You should think carefully about the tax rate you’re willing to pay before deciding how much to convert.
You might also want to convert if taking a required distribution from your traditional retirement account will leave you with more income than you need — and an unusually high tax bill. This is a situation some retirees age 70½ face. Roth accounts have no required minimum distribution rules, so they make more sense for some retirees with large account balances.
Roths also have strong tax benefits for heirs. They remain tax-free, even when passed on.
Consult a pro
The benefits of a Roth conversion can be substantial, but so can the costs. Make sure you understand how it would impact your tax and retirement planning before you act — ideally, by consulting with a financial planner who’s familiar with your financial situation.
This article first appeared at NerdWallet.
