Should You Convert Your Traditional IRA to a Roth?
Most people spend their working years trying to reduce their tax bill. So the idea of voluntarily creating taxable income can seem strange.
But that's exactly what happens with a Roth conversion. You move money from a traditional IRA or other eligible retirement account into a Roth IRA and generally pay income tax on the amount converted today.
The real question is simple:
Is paying the tax today better than paying it later?
For some people, the answer is yes. For others, converting simply accelerates a tax bill that would have been better left for another day.
Retirement Can Create a Tax Window
Some of the best opportunities for Roth conversions can occur during the transition into retirement.
Imagine retiring at 62. Your paycheck stops, you haven't started Social Security, and required minimum distributions haven't begun. You may have substantial assets in a traditional IRA or 401(k), but your taxable income could temporarily be much lower than it was while you were working.
Instead of trying to pay as little tax as possible during those years, it may make sense to intentionally recognize some income through Roth conversions.
A low-tax year can be an asset. Sometimes it makes sense to use it.
Think Beyond This Year's Tax Rate
The basic argument for a Roth conversion is that you believe the money will ultimately be taxed at a higher rate if you leave it in the traditional account.
That doesn't necessarily require predicting what Congress will do.
Your personal tax situation can change on its own. Social Security can begin. Pension income may start. Required minimum distributions can increase taxable income later in retirement. And after one spouse dies, the survivor may eventually file as a single taxpayer while still owning much of the couple's retirement assets.
That's why we look at taxes over a lifetime rather than one year at a time.
What If You Don't Need the Money?
For some retirees, the Roth conversion decision eventually becomes an estate-planning decision.
If your financial plan shows that you're unlikely to spend all of your retirement assets, we need to think about who may eventually inherit them.
Under current rules, many non-spouse beneficiaries are generally required to empty inherited retirement accounts by the end of the tenth year following the owner's death.
If your children inherit a large traditional IRA while they're in their peak earning years, those distributions could arrive on top of already substantial income.
That raises an interesting question:
Who should pay the tax, and when?
In some cases, converting portions of an IRA during retirement may be preferable to leaving the entire tax liability attached to the account for the next generation.
How You Pay the Tax Matters
A conversion creates a tax bill, and where that money comes from is important.
If you can pay the tax from cash or other non-retirement assets, the entire converted amount can remain invested in the Roth. If part of the retirement distribution is used to pay the tax, less money makes it into the Roth.
That doesn't make one approach automatically right or wrong, but it can materially affect whether the conversion makes sense.
Don't Just Fill a Tax Bracket
One common strategy is to convert enough money to reach the top of a particular federal tax bracket.
That's useful information, but it isn't enough.
Additional income from a conversion can affect Medicare income-related premiums, the taxation of Social Security benefits, state income taxes, deductions and credits, and other income-based thresholds.
We want to understand the total cost of recognizing another dollar of income, not simply the federal tax bracket.
The Answer May Be a Series of Smaller Conversions
Roth conversion planning doesn't have to be all or nothing.
Someone with a large traditional IRA might convert a portion this year, another portion next year, and continue during years when taxable income is relatively low. That may be more attractive than converting a large account all at once and creating an unnecessarily large tax bill.
For many people, the better question isn't, "Should I convert my IRA?"
It's "How much should I convert this year?"
The Goal Is Lifetime Tax Planning
A Roth conversion isn't right for everyone.
If you're paying a high tax rate today and expect a meaningfully lower one later, converting may not make sense. The same may be true if you'll need the money soon, don't have an attractive way to pay the tax, or the additional income creates other undesirable consequences.
Good tax planning isn't about paying the smallest possible tax bill every April. It's about managing taxes over your lifetime.
There may be years when intentionally paying more tax today improves your long-term financial picture. There will be other years when doing nothing is the better decision.
That's why Roth conversions should begin with the financial plan, not the tax bracket.
If you'd like to talk about whether Roth conversions should be part of your retirement and tax strategy, we'd be happy to help. Schedule a complimentary 15-minute call.
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This material was written in collaboration with artificial intelligence (ChatGPT) and derived from sources believed to be correct.
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