Is your traditional IRA or 401(k) down in value this year? Many financial experts are touting this as a good time to convert it to a Roth since you can pay taxes on the lower account value, and when the market recovers, your money can grow to be tax-free. However, here are some reasons why it might actually not be a good 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 since that money will no longer be growing for your retirement. This is even more of a concern if the withdrawal is subject to a 10% early withdrawal penalty. Ideally, you would pay the taxes from money outside the retirement account.
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 $120k this year. Since some of your income won’t be taxed at all due to deductions, your taxable income might be no more than $100k. This puts you in the 22% tax bracket.
However, the first $20,550 of your taxable income would only be taxed at 10%. Then everything from there up to $83,550 is taxed at 12%. Only the income over $83,550 is taxed at the 22% rate. As a result, someone with $100k of taxable joint income in retirement could be in the 22% bracket but pay only about 13% of their taxable income in taxes. You can see your marginal tax bracket and effective tax rate here.
3) You have a child in college. A Roth conversion would increase your reported income and potentially reduce your child’s financial aid eligibility.
Of course, there are also situations where a Roth conversion makes sense:
1) You think your tax rate could be higher upon withdrawal. You may not have worked at least part of the year or earned a reduced income, have larger than usual deductions, or have other reasons to be in a lower tax bracket this year. Perhaps you’re getting a large pension or have other assets that will fill in the lower tax brackets in retirement. Maybe you’re worried about tax rates going up by the time you retire, or you may intend to pass the account on to heirs that could be in a higher tax bracket. In any of those situations, a Roth conversion lets you pay the taxes on your account before the tax rate goes up.
2) You have money to pay the taxes outside of the retirement account. For example, let’s say you have $22k sitting in a savings account, and you’re going to convert a $100k pre-tax IRA to a Roth IRA. At the 22% tax rate, the $100k pre-tax IRA is equivalent to a $78k Roth IRA. If you convert it and use 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 $22k “contribution” to the Roth IRA.
Had you simply invested the $22k 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.
3) 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.
4) You want to avoid required minimum distributions (RMDs). Unlike traditional IRAs, 401(k)s, and other retirement accounts, Roth IRAs are not subject to RMDs. This lets more of your money grow 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.
Want to do a Roth conversion but worried about the tax bite? Keep in mind that Roth conversions don’t have to be a one-time-only event. You can do multiple conversions over several years and spread the tax impact over that time 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 do. Instead, ask yourself if it’s a good time for you based on your situation. If not, you can always convert when the timing is right.