It is often advisable to convert funds from an IRA or similar tax-deferred retirement account to Roth in a year when you are in a lower tax bracket in order to save money in the short-term. Having said that, there are other considerations. Many people like the idea of transferring IRA funds to Roth accounts because Roth withdrawals are usually tax-free and Roth accounts are not subject to mandatory withdrawal rules (RMDs), among other benefits. However, converting can generate a large current tax bill. Converting now may not be the best idea if you expect to be in a lower tax bracket after retiring, if you lack non-retirement assets to pay the tax bill or will need to start withdrawing from the Roth within five years.
A financial advisor can help you balance the pluses and minuses of a Roth conversion in your situation.
Roth Conversion Rules
A Roth conversion involves transferring assets from a traditional IRA or 401(k) to a Roth IRA. There are several reasons to consider this move, including the fact that retirement withdrawals from Roth accounts are tax-free. Funds in a Roth are also not subject to Required Minimum Distribution (RMD) rules. For estate planning purposes, your beneficiaries can inherit Roth funds tax-free. And the income caps on Roth contributions don't apply to conversions. You can convert as much as you want, as often as you want.
Despite these pluses, there are reasons you may not want to convert funds from an IRA to a Roth. One is that converted funds are taxable. Your current taxable income will increase by the amount of any funds you convert. That temporarily can push you into a higher marginal income tax bracket and lead to a large tax bill. Because of this, it can make sense to time a Roth conversion to occur in a year when your taxable income is lower than usual.
However, there are some other considerations. Your income and tax bracket after you retire may be more important than whether your current income is less than last year's. If you expect to be in a lower tax bracket after you retire, it may make sense to leave the funds in your traditional IRA and pay taxes on withdrawals at your lower post-retirement rate than at your higher current rate.
Another time conversion makes less sense is if you will need the funds within the next few years. That's because of the five-year rule, which can impose a penalty on converted funds withdrawn within five years of the conversion in most cases. Because of this, it's important to know that conversion is a one-way street. Once you convert funds, you can't undo the process. So it's advisable to carefully consider your income needs and future tax situation carefully before doing a conversion.
With this in mind, people may convert only part of their IRA in order to maintain flexibility along with the potential for reducing their overall taxes. A refinement of that approach involves gradually converting a portion of the IRA each year for several years. Gradual conversion can improve someone's ability to pay taxes without tapping converted funds and may reduce their overall tax liability.
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Roth Conversion in Action
The average retirement account balance for a household headed by someone aged 55 to 64 is approximately $185,000, according to the Federal Reserve. Average income in the same age group, in round numbers, is $65,000 per year. For a single filer in 2023, this income would put them in the 22% bracket and result in an income tax bill of $6,561. If they convert the full value of that average retirement account from an IRA to a Roth account, their total income would increase to $250,000, lifting them into the 35% bracket after adjustments and increasing taxes owed to $54,547.
If this saver's income dropped to $45,000 one year, they could convert the $185,000 IRA and have total income of $230,000. This would put them in the 24% bracket and result in a tax bill of $48,000, saving $6,547 over doing it in a normal income year.
So, in short, it could save a significant amount to convert an IRA to a Roth during a year when income was reduced. To plan most effectively for retirement, however, it's also likely necessary to consider doing a partial or gradual conversion, or not converting at all. Remember, a financial advisor can help you execute an appropriate conversion strategy based on your circumstances.
Bottom Line
Doing a Roth conversion in a year when your income is down can save on your current tax bill compared to doing it in a normal year. You may want to consider this if you expect to be in a higher tax bracket after retirement and have other assets to pay the tax levied on the conversion. Other options include gradual or partial conversion. Converting IRA funds to a Roth can let you make tax-free withdrawals later on as well as avoid RMDs and pass on retirement assets tax-free as part of your estate. However, you may not benefit from conversion if will be in a lower tax bracket when you retire, already live in a low-tax state, don't have non-retirement assets to pay the conversion tax bill or don't plan to leave retirement account assets to your heirs.
Tips
- Consider tapping the expertise of a financial advisor when considering a Roth conversion. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
- Do you expect to have to take Required Minimum Distributions from your tax-deferred retirement account? If so, boost your future tax planning by calculating the amount of the mandatory withdrawals using SmartAsset's RMD Calculator.
- Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
- Are you a financial advisor looking to grow your business? SmartAsset AMP helps advisors connect with leads and offers marketing automation solutions so you can spend more time making conversions. Learn more about SmartAsset AMP.
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