4 Considerations to Make Before Doing a Roth Conversion
There are two common types of individual retirement accounts (IRA) that you can invest in when saving for retirement: a Roth IRA and a traditional IRA. When reviewing some of their key differences, it’s important to ask yourself: “When is the most advantageous time to pay tax on my income?”
We often have conversations with clients about Roth conversions and whether or not it makes sense for their situation. Typically, this question comes up when someone is starting a new job and considering what to do with their existing IRA and enrolling in a new plan.
Should you consider taking advantage of this opportunity, or are you better off sticking to your current savings strategy? We’re discussing what you need to know below.
What Is a Roth Conversion?
A Roth conversion refers to the act of converting a traditional IRA account into a Roth IRA account. A traditional IRA account is created using pre-tax dollars, meaning the distributions you take from a traditional IRA account in retirement is taxable income. A Roth IRA is created using after-tax dollars, meaning the distributions you take from a Roth IRA account in retirement is tax-free (because tax has already been paid).
Additionally, a Roth IRA can be an appealing option for some because it does not include a required minimum distribution age. This means that you can continue to save and grow tax-free dollars for the remainder of your life.
Considerations to Make Before Doing a Roth Conversion
While a Roth conversion could be a great option for some, it could be a costly mistake for others. That’s why we’ve outlined four important considerations to make before converting your traditional IRA into a Roth account.
#1: Your Timeline to Retirement
If you’re retiring within the next few years, you may want to forego a Roth conversion. Why? Because the money you convert into a Roth IRA must stay there for a five-year holding period. If withdraws are made before the five years is up, you could be hit with a 10 percent penalty and/or additional income taxes.
#2: Tax Obligations
When considering a Roth conversion, you simply can’t ignore the tax implications associated with this move. While your aim may be tax-free income in retirement, you will have to pay taxes on that income at some point. You need to be prepared to pay the taxes on this additional income, which could very well push you up into a higher tax bracket. While it’s possible to cover the difference using a portion of the distribution itself, this is typically not advised for two reasons: you’d be robbing your future retirement of income and you may be subject to a 10 percent penalty for taking the funds.
#3: Your Future Tax Bracket
One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement. With that in mind, you’ll want to take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds. If you believe you’ll be in a lower tax bracket come retirement, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of interrupted or lowered income (lost a job, missed out on a bonus, etc.), you may be in a lower tax bracket now than you would when entering retirement.
#4: How Much to Convert and When
If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation.
Being able to withdraw income tax-free in retirement is an appealing option for many. And it’s good to know that while you may have chosen to open a traditional IRA years ago that you have the option to convert it at any time. We encourage you to reach out to our team with questions and to discuss what is best for your financial situation.