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Is a Roth Conversion Right for Me? And When You Should Consider

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Is a Roth Conversion Right for Me? And When You Should Consider
May 10, 2022

A Roth conversion is a strategy that we implement with our clients when the markets are down, or when we project future tax savings on a conversion. Today’s blog post will help you learn what a Roth conversion is and whether it’s appropriate for your situation.

What is a Roth conversion?

A Roth conversion is simply moving funds from a Traditional IRA (or 401(k)) to a Roth IRA (or Roth 401(k)). You are essentially taking dollars that you haven’t paid taxes on yet and converting them to an account where you have already paid taxes.

What are the tax implications?

When you originally contributed to your Traditional IRA (or 401(k)), you received a tax deduction based on the amount that you contributed to your retirement account. In this type of account, it will grow tax-deferred and you are not required to pay any taxes until you make a distribution which for most people that will be in retirement. When you make contributions to a Roth IRA, you are contributing funds that you have already paid taxes on. Once those funds are inside of the Roth, they will grow tax-free from the point forward.

So, when you convert dollars from a pre-tax account to a post-tax account, you must pay taxes on the amount that you convert, but again, from that point forward the account will grow tax-free! You can either withhold the taxes on the conversion which will cut into the amount you convert to the Roth, or you can convert the whole amount and pay the taxes out of pocket when you file your taxes.

What are the age and income limits?

Based on your age and income levels, not everyone is allowed to make Roth contributions. Roth conversions on the other hand, can be done by almost anyone. There are rules and items to consider if you are 72 or older (RMD age), and if you have non-deductible Traditional IRA dollars.  However, most people are eligible to take advantage of a Roth conversion.

What are the reasons I would do a Roth conversion?

You’re in a lower tax bracket right now:  The biggest reason we process Roth conversions is because we anticipate taxes being lower today than they will be in retirement. Think about it, tax rates are probably the lowest they will ever be. Especially with the amount of debt the US continually piles on. By paying taxes now, you’re essentially getting a discount on the taxes that you will have to pay later on by not converting.                        

The market is down:  Remember how I said that every dollar that you convert from a pre-tax account to a post-tax account, you will have to pay taxes on? Well, if you complete the conversion while the market is down (and your account value is down), you’re paying less in taxes because the value is less. When the market eventually recovers, that’s a pretty impressive tax-free recovery not to mention the continued tax-free growth in the account as the investments appreciate.

What else should I know about Roth conversions?

A Traditional IRA can easily be converted by calling your custodian and requesting the conversion, but, not all 401(k) plans allow a Roth conversion. This is something you would have to research and if for any reason it isn’t available, it doesn’t hurt to reach out to the plan’s administrator and request this change.

Another point to be aware of, is to be mindful of the amount that you decide to convert. Again, any amount that you choose to convert will be considered taxable income and could potentially launch you into a higher tax bracket. Instead of doing a large lump sum at once, you may want to complete the conversion in installments over several years.

If you’re not sure if this is the right strategy for you or you want to talk it through, schedule a time with us to chat.

Interested in learning more about Beyond Balanced Financial Planning?  

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