When Does A Roth IRA Conversion Make Sense

When Does A Roth IRA Conversion Make Sense

Converting your traditional IRA to a Roth IRA can be a great retirement planning strategy but it’s not the right move for everyone. Here are the things to consider before making the move.

Compare Your Tax Rates

The number one thing to consider before converting a traditional IRA to a Roth IRA is whether you think your future marginal tax rate will be higher than your current marginal tax rate. If you think the future rate will be higher then it is usually beneficial to convert your IRA. But if you think your marginal tax rate will be lower or about the same when you begin withdrawing from your IRA, then there may be little or no benefit to converting your IRA into a Roth IRA.

Your current marginal rate is straightforward to estimate by looking at last year’s tax returns and this year’s tax brackets (assuming your income and deductions haven’t changed too much). Also notice if adding the converted amount to your income pushes you into a higher marginal tax bracket.

Your future marginal tax rate is harder to estimate. If you are young and at the lower end of your expected pay scale then it’s a good bet your marginal tax rate will be higher when you retire.

But if you are in a high tax bracket already then it will be harder to determine if your future tax rate will be higher or lower. Try to estimate what your marginal tax rate will be during retirement when you start to withdraw from your IRA. You’ll want to consider any income you expect to receive during retirement in addition to social security, pensions, and required minimum distributions (RMDs) from your traditional IRA.

How to Pay for the Roth IRA Conversion

How you pay the taxes on your Roth IRA conversion will also have an impact on your bottom line over time. The amount you convert will be considered ordinary income. So if  you are converting an IRA worth $50,000 and your marginal tax rate is 25%, you’ll pay $12,500 in income taxes.

One option is to pay the tax with part of the IRA you’re converting. The downside of this is that you’ll now have less in your Roth IRA account. The other downside is that if you’re younger than 59 1/2, you’ll pay a 10% penalty on any IRA withdrawals.

A better option is to pay from funds you have outside of your retirement accounts and maximize the amount that will stay in the Roth IRA. This amount will now be earning tax-free returns and will most likely grow faster than funds held in a taxable account.

Timing of a Roth IRA Conversion

A Roth IRA is often recommended for younger people because it is likely they’ll move up into higher tax rate brackets as they age. But it can also make sense for people that have a lower amount of income for one year. This can happen if someone is out of work or taking some scheduled time off from the work force.

The lower income for the year will put you in a lower tax bracket. Now your current marginal rate will most likely be lower than your future tax rate. Just be careful the conversion doesn’t move you unexpectedly into a higher tax bracket.

Stock Market Corrections

Another time to consider a Roth IRA conversion is when the amount in your traditional IRA has dropped due to poor performance in the market. If you find the amount in your IRA has dropped 25% then you’ll now pay 25% less in taxes on the Roth conversion. And when the market rebounds, the amount will now be growing tax-free.

Other Roth IRA Benefits

Although comparing tax rates is the main consideration when deciding whether to convert a traditional IRA to a Roth IRA, there are some other benefits that can give a Roth IRA a slight advantage:

– There is no required minimum distribution (RMD) for Roth IRAs. With a traditional IRA, you’ll have to start withdrawing a minimum amount at age 70 1/2 and paying ordinary income taxes on that amount.

– You can pass on a Roth IRA tax free to you heirs. With a traditional IRA, your beneficiaries will have to pay ordinary taxes on the amount of the inherited IRA.

– The amount that you’ve contributed to a Roth IRA can be withdrawn without penalties at anytime. The earning can be withdrawn if you’ve held the account for at least five years and are at least age 59 1/2 or the funds are being used for qualified expenses. (The rule is different however for the amount converted from the IRA. You have to wait 5 years before withdrawing the converted amount penalty free.)

– Having both a traditional IRA and a Roth IRA will give you more flexibility at tax time during retirement. You can withdraw more from a Roth when you have a high income year and more from an IRA during a low income year to minimize taxes.

The driving factor though is the tax rate rate comparison. Estimating both your current and future marginal tax rates will give you a clearer picture of what’s the right move for you. 

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The content on this post is for information purposes only and is not intended to provide individual tax or financial advice. Readers are advised to consult financial or tax professionals for specific information regarding your individual situation. Opinions expressed herein are solely those of Balance Financial Planning, LLC, unless otherwise specifically cited. The content is developed from sources believed to be providing accurate information.

Balance Financial Planning, LLC

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Oakland, CA 94618