One of the most common questions I receive, as a CERTIFIED FINANCIAL PLANNER™️, from clients is about Roth conversions. With proper planning, converting traditional retirement accounts to Roth accounts can be a powerful tax planning strategy. Let me break down everything you need to know about when, why, and how to execute a Roth conversion.
What is a Roth Conversion?
A Roth conversion is the process of moving money from a traditional IRA or 401(k) into a Roth IRA. While simple in concept, this strategy requires careful consideration because you’ll need to pay income taxes on the converted amount in the year of conversion.
When Should You Consider a Roth Conversion?
In my practice, I’ve identified several optimal scenarios for Roth conversions:
- During Low-Income Years: Perhaps you’re between jobs, recently retired, or starting a business. These lower-income years present an opportunity to convert at lower tax rates.
- Before Required Minimum Distributions (RMDs): Converting before age 73 can help reduce future RMDs and provide more control over your retirement income.
- Market Downturns: Converting when account values are temporarily depressed means paying taxes on a lower amount while capturing future recovery in a tax-free account.
- Early Retirement Years: The window between retirement and Social Security/RMDs often presents a prime conversion opportunity.
Why Consider a Roth Conversion?
The benefits of Roth conversions go beyond the obvious tax-free growth:
Tax Diversification
Having both traditional and Roth accounts gives you flexibility in managing your retirement tax bracket. I often tell clients it’s like having different tax buckets to draw from based on your needs.
Estate Planning Advantages
Roth IRAs don’t have RMDs during your lifetime, making them excellent wealth transfer vehicles. Your beneficiaries will inherit tax-free assets rather than tax-deferred ones.
Insurance Against Future Tax Rates
With current federal deficit levels and changing tax legislation, having tax-free money in retirement can help hedge against potentially higher future tax rates.
How to Execute a Roth Conversion
As your financial planner, here’s my recommended approach:
1. Strategic Planning
First, we need to analyze your current and projected future tax brackets. We’ll look at:
- Your current income and tax bracket
- Projected future income
- State tax implications
- Impact on other tax-sensitive items like Medicare premiums
2. Timing the Conversion
Consider breaking up large conversions over several years to manage tax brackets. We might convert just enough to “fill up” your current tax bracket without pushing into the next one.
3. Funding the Tax Bill
Have a plan to pay the conversion taxes without using the converted funds. Using outside money to pay the tax bill maximizes the benefit of the conversion.
4. Administrative Details
- Ensure proper documentation for the IRS
- Consider estimated tax payments to avoid penalties
- Maintain records of your basis in any nondeductible IRAs (crucial for the pro-rata rule)
Common Pitfalls to Avoid
In my years of practice, I’ve seen clients make several common mistakes:
- Converting too much at once and pushing themselves into a higher tax bracket
- Not considering the impact on Medicare premiums
- Failing to account for state tax implications
- Missing the 5-year rule for penalty-free withdrawals
Final Thoughts
Roth conversions can be a powerful tool in your retirement planning toolkit, but they require careful analysis and execution. As your financial planner, I recommend we review your specific situation annually to identify optimal conversion opportunities.
Remember, while the tax-free growth of Roth accounts is attractive, the decision to convert should always be part of your broader financial plan, taking into account your current circumstances, future goals, and overall tax strategy.
Want to discuss whether a Roth conversion makes sense for your situation? Let’s schedule a review of your retirement strategy and explore your options together.