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Hands holding piggy bank with Roth IRA. Pension plan.
There’s been a lot of talk about whether the backdoor Roth IRA and mega back door Roth conversions will be eliminated. However, this isn’t the only reason to convert money to Roth. The most common reason is to pay taxes on pre-tax money now so the money can grow to be eventually tax-free. Let’s take a look at some pros and cons, starting with reasons why now might not be the time for a Roth conversion:
1) The investments in the account have been doing very well. Considering that you have to pay ordinary income taxes in the tax year when you do the conversion, and the market tends to move in cycles, do you really want to pay taxes when your account balance is particularly high or when the value is eventually lower?
2) You have to withdraw money from the retirement account to pay the taxes. If you have to pay the taxes from money you withdraw from the account, it usually doesn’t make financial sense since that money will no longer be growing for your retirement. This is even more of a tax concern if the withdrawal is subject to a 10% early withdrawal penalty.
3) You’ll pay a lower tax rate in retirement. This can be a tricky one because the tendency is to compare your current tax bracket with what you expect it to be in retirement. There are a couple of things to keep in mind though.
One is that the conversion itself can push you into a higher tax bracket. The second is that when you eventually withdraw the money from your non-Roth retirement account, it won’t all be taxed at that rate. Let’s take an example where you retire with a joint income of $120k this year. Since you’d get at least a $25,900 joint standard deduction, your taxable income would be no more than $94,100, which puts you in the 22% tax bracket. However, the first $20,550 of income would be taxed at just 10%. Then everything from there up to $83,550 is taxed at 12%.
Only the income over $83,500 is taxed at the 22% rate. As a result, someone with $94,100 of taxable income could be in the 22% bracket but pay only about 12.7% of their taxable income in taxes. You can see your marginal tax bracket and effective tax rate here.
4) You have a child in college. A Roth conversion would increase your reported income and potentially reduce your child’s financial aid eligibility.
Of course, there are also situations where a Roth conversion makes sense:
1) Your investments are down in value. This could be an opportunity to pay taxes on them while they’re low and then have a long-term investment time horizon to allow them to grow tax free. When the markets give you a temporary investment lemon, a Roth conversion lets you turn it into tax lemonade.
2) You think the tax rate could be higher upon withdrawal. You may not have worked at least part of the year (in school, taking time off to care for a child, or just in between jobs), have larger than usual deductions, or have other reasons to be in a lower tax bracket. Perhaps you’re getting a large pension or have other assets that will fill in the lower tax brackets in retirement. Maybe you’re worried about tax rates going higher by the time you retire or you intend to pass the account on to heirs that could be in a higher tax bracket. In any of those situations, a Roth conversion lets you pay the taxes on your account before the tax rate goes up.
3) You have money to pay the taxes outside of the retirement account. By using the money to pay the tax on the conversion, it’s like you’re making a “contribution” to the account. Let’s say you have $22k sitting in a savings account and you’re going to convert a $100k pre-tax IRA to a Roth IRA. At the 22% tax rate, the $100k pre-tax IRA is equivalent to a $78k Roth IRA.
By converting and using money outside of the account to pay the taxes, the $100k pre-tax IRA balance becomes a $100k Roth IRA balance, which is equivalent to a $22k “contribution” to the Roth IRA. Had you simply invested the $22k in a taxable account, you’d have to pay taxes on the earnings; by “transferring” the value into the Roth IRA the earnings grow tax free. This calculator helps you crunch your own numbers.
4) You want to use the money for a non-qualified expense in 5 years or more. After you convert and wait 5 years, you can withdraw the amount you converted at any time and for any reason, without tax or penalty. Just be aware that if you withdraw any post-conversion earnings before age 59½, you may have to pay income taxes plus a 10% penalty tax.
5) You want to avoid required minimum distributions (RMDs). Unlike traditional IRAs, 401(k)s, and other retirement accounts that require distributions starting at age 72, Roth IRAs are not subject to RMDs. This lets more of your money grow tax free for longer.
If this is your motivation, remember that you can always wait to convert until you retire, when you might pay a lower tax rate. Also keep in mind Roth conversions are not a one-time-only event. You can do multiple conversions and spread the tax impact over different tax years if you are concerned about pushing your income into a higher tax bracket in any particular year.
There are good reasons to convert and not to convert to a Roth. Don’t just do what sounds good or blindly follow what other people are doing. Ask yourself if it’s a good time for you based on your situation.