When thinking about Roth conversions it is important to keep a few basic IRA concepts in mind. First, a traditional IRA contains pre-tax dollars and every penny you withdraw from it counts as ordinary income on your tax return for that year. Secondly, a Roth IRA contains after-tax dollars and qualified withdrawals are tax-free. When you convert traditional IRA money to Roth it is a taxable event. Whatever amount you convert will count as income to you that year.
Now that we’ve got a few basics down… when and why would someone do a Roth conversion? There are many scenarios to consider. All things equal – which is never the case, but – the younger you are the more it makes sense to do a Roth conversion. If you are young, you have lots of time for the new Roth money to grow and make up for the taxes you had to pay to execute the conversion. However, if you are older you may want to create a tax-free asset that you can pass along to the next generation, and in that case your time-horizon is longer than it would normally be given your age.
But even if you are a few years away from retirement and have no plans to pass on assets to the next generation, a Roth conversion can make sense. For example, if tax rates are higher in the future – a real possibility – then paying the tax now can save you money in the long run.
There are two other rules of thumb to use when considering a Roth conversion. First, are you able to pay the tax that will be owed out of pocket? To keep the full amount of the conversion in the Roth IRA this will need to be done. This is especially true if you are older. If you are on the young side and the account is small, then having the taxes withheld from the conversion dollars is OK in my opinion. Second, will the conversion push you into another tax bracket? There is a conversion strategy known as “stuffing the bracket”. This means you convert enough money to get your income up to the next bracket but not over.
If you find yourself in a position where your taxable income will be abnormally lower for some reason in one year, that could be the perfect time to do a Roth conversion. Perhaps you will retire in the first half of the year and will be living off your savings the rest of the year. Or maybe you are self-employed, and the business showed very little income that year for whatever reason.
For most people who are doing Roth conversions, a strategy where you convert IRA money over a few years is best as opposed to doing one big lump sum. Having too much income in any given year can have many unwanted tax side effects. A higher income on paper can lead to higher Medicare Part B premiums, higher capital gains tax rates and more taxes on your Social Security retirement benefits. There is a lot to consider with Roth conversions, so be sure to talk it over with your financial advisor and tax accountant.