Is It The Right Time To Convert To A Roth?

Are you wondering if you should convert your retirement account to a Roth by the end of the year? After all, there’s no income limit on IRA conversions and many employers are now allowing employees to convert their company retirement plan balances to Roth while they’re still working there. At first glance, it may sound appealing since the earnings in a Roth can grow tax free, and who doesn’t like tax free? However, here are some reasons why now might not be the time for a Roth conversion:

1) You have to withdraw money from the retirement account to pay the taxes. If you have to pay the taxes from money you withdraw from the account, it usually doesn’t make financial sense as that money will no longer be growing for your retirement. This is even more of a tax concern if the withdrawal is subject to a 10% early withdrawal penalty.

2) You’ll pay a lower tax rate in retirement. This can be a tricky one because the tendency is to compare your current tax bracket with what you expect it to be in retirement. There are a couple of things to keep in mind though. One is that the conversion itself can push you into a higher tax bracket. The second is that when you eventually withdraw the money from your non-Roth retirement account, it won’t all be taxed at that rate.

Let’s take an example where you retire with a joint income of $124,400 this year. Because of the $24,400 standard deduction for married filing jointly, your taxable income would be no more than $100,000. Of your taxable income, the first $19,400 would only be taxed at 10%, and everything from there up to $78,950 is taxed at 12%. Only the income over $78,950 is taxed at the 22% rate. As a result, you would be in the 22% bracket but actually pay only about 15% of your income in taxes.

You can calculate your marginal tax bracket and effective average tax rate here for both your current and projected retirement income. (Don’t factor in inflation for your future retirement income since the tax brackets are adjusted for inflation too.) The tax you pay on the conversion is your current marginal tax bracket, but the tax you avoid on the Roth IRA withdrawals is your future effective average tax rate.

3) You have a child applying for financial aid. A Roth conversion would increase your reported income on financial aid forms and potentially reduce your child’s financial aid eligibility. You can estimate your expected family contribution to college bills based on your taxable income here.

Of course, there are also situations where a Roth conversion makes sense:

1) Your investments are down in value. This could be an opportunity to pay taxes on them while they’re low and then have a long-term investment time horizon to allow them to grow tax free. When the markets give you a temporary investment lemon, a Roth conversion lets you turn it into tax lemonade.

2) You think the tax rate could be higher upon withdrawal. You may not have worked at least part of the year (in school, taking time off to care for a child, or just in between jobs), have larger than usual deductions, or have other reasons to be in a lower tax bracket this year. In that case, this could be a good time to pay the tax on a Roth conversion.

You may also rather pay taxes on the money now since you expect the money to be taxed at a higher rate in the future. Perhaps you’re getting a large pension or have other income that will fill in the lower tax brackets in retirement. Maybe you’re worried about tax rates going higher by the time you retire. You may also intend to pass the account on to heirs that could be in a higher tax bracket.

3) You have money to pay the taxes outside of the retirement account.  By using the money to pay the tax on the conversion, it’s like you’re making a “contribution” to the account. Let’s say you have $25k sitting in a savings account and you’re going to convert a $100k pre-tax IRA to a Roth IRA. At a 25% tax rate, the $100k pre-tax IRA is equivalent to a $75k Roth IRA. By converting and using money outside of the account to pay the taxes, the $100k pre-tax IRA balance becomes a $100k Roth IRA balance, which is equivalent to a $25k “contribution” to the Roth IRA. 

Had you simply invested the $25k in a taxable account, you’d have to pay taxes on the earnings. By transferring the value into the Roth IRA, the earnings grow tax free. This calculator helps you crunch your own numbers.

4) You want to use the money for a non-qualified expense in 5 years or more. After you convert and wait 5 years, you can withdraw the amount you converted at any time and for any reason, without tax or penalty. Just be aware that if you withdraw any post-conversion earnings before age 59½, you may have to pay income taxes plus a 10% penalty tax.

5) You might retire before age 65. 65 is the earliest you’re eligible for Medicare so if you retire before that, you might need to purchase health insurance through the Affordable Care Act. The subsidies in that program are based on your taxable income, so tax-free withdrawals from a Roth account wouldn’t count against you.

6) You want to avoid required minimum distributions (RMDs). Unlike traditional IRAs, 401ks, and other retirement accounts that require distributions starting at age 70½, Roth IRAs are not subject to RMDs so more of your money grows tax free for longer. If this is your motivation, remember that you can always wait to convert until you retire, when you might pay a lower tax rate. Also keep in mind, Roth conversions are not a one-time-only event. You can do multiple conversions and spread the tax impact over different tax years if you are concerned about pushing your income into a higher tax bracket in any particular year.

There are good reasons to convert and not to convert to a Roth. Don’t just do what sounds good or blindly follow what other people are doing. (If you did and mistakenly did a Roth conversion this year, you have until October 15th of next year to undo it.) Ask yourself if it’s a good time for you based on your situation or consult an unbiased financial planner for guidance. If now is not the right time, you can always convert when the timing is right.

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