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聽hype surrounds Roth IRAs 鈥� which can offer significant聽tax savings for some investors 鈥� the decision can be complicated.
A traditional IRA or聽401(k) is funded with 鈥減retax鈥� money. This money may have been withheld from your paycheck before taxes were computed, or you may have received a聽tax deduction on your IRA contribution. These contributions grow tax-free. When you take a withdrawal from your 401(k) or traditional IRA,聽you鈥檒l pay taxes on both the money you put in聽and any gains you earned.
You fund a聽聽with money that has already been taxed. When you withdraw money from a聽Roth, you聽won鈥檛聽pay taxes on either the amount you invested聽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鈥檙e working and paying a high tax rate,聽the immediate tax benefits of a traditional retirement plan outweigh the longer-term advantages of a聽Roth. You can invest more聽when you include your tax savings.
However, the lower your income, the lower your tax rate, which聽means you鈥檒l 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聽a Roth conversion, you pay tax on the converted amount as if it were聽a withdrawal 鈥斅燽ut you won鈥檛 pay a聽聽(before age 59陆).
The decision to do so is generally opportunistic. You might want to do it if your taxable income was聽unusually low this year, for example, if you聽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鈥檇 ordinarily be in the 25% or 28% tax bracket, this opportunity might be too good to pass up.
Remember that the amount you convert聽will be added to your income. You should聽think carefully about the tax rate you鈥檙e 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 鈥� and an unusually high tax bill. This is a situation some retirees age 70陆 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 鈥� ideally, by consulting聽with a financial planner who鈥檚 familiar with your financial situation.
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