Roth conversions can be a powerful tool to move money from tax-deferred accounts into tax-free accounts. I think of two major situations where Roth conversions can make a lot of sense.
The first situation is for an individual whose income may be significantly lower this year than in previous years or expected future years. Examples of this may be someone starting a business this year where they previously had a salary or someone in sales that had their lowest producing year. This can provide a great opportunity for Roth conversions. While in a lower tax bracket, you can convert money from pre-tax buckets to Roth buckets, paying tax on those assets now and letting them grow tax-free. If you’ve previously been in the 22% federal bracket and expect to be there in the future as well, converting money while in a lower tax bracket such as the 12% bracket can make a lot of sense. The benefits here are paying tax on these assets at a lower rate than in other years and increasing your tax-free bucket of money. Before converting, make sure that you have enough cash available to pay tax on the conversion come tax time. Withholding taxes on this conversion counts as an early withdrawal if you're under age 59.5. So, for those under age 59.5, we recommend avoiding tax withholding on the conversion and paying the tax with cash assets.
The other situation is for retired individuals who’s Required minimum distributions (RMDs) have yet to kick in. Consider your current tax bracket and expected tax bracket when RMDs kick in. If you're in a lower tax bracket now then you expect to be when RMDs kick in, it may make sense to convert to the top of your current tax bracket. The benefits here are paying tax on assets at a lower rate, building your tax-free bucket of money, potentially lowering future RMDs by decreasing the balance in tax-deferred assets, and decreasing the odds of RMDs bumping you into a higher tax bracket. Remember: Medicare premium income limits need to be accounted for here as well.
There are some additional considerations to think about when converting tax-deferred funds to a Roth as well.
1. Roth IRAs can allow you to pass money on to your heir’s tax free. In my opinion, this is the best account to inherit because all distributions from the account are tax free given current tax laws.
2. Down markets can be an optimal time for Roth conversions. When the markets are down, you can convert money from tax-deferred assets to Roth. Then, when the markets recover, the growth is now tax free.
Like everything, everyone’s situation is different so there is a never a one-size fits all approach to Roth conversions. These are just some considerations on when they can be useful and the benefits that can be provided.
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