A Roth conversion can potentially save you a lot of money over your lifetime. It is a long-term (years or decades-long) strategy, to be sure. It is one that is usually talked about in the context of retirees.
But there are plenty of opportunities for much younger folks, still in the midst of their career and earning years (say, a gal like you!), to take advantage of it. And the earlier you do it, the more years you have to benefit from it.
First, let me explain what is this “Roth conversion” thing I speak of.
What is a Roth Conversion?
You know about 401(k)s and IRAs, right? (If you don’t, go learn about them elsewhere and come back.)
Each comes in two flavors:
- Tax deferred: You get a tax break now for your contribution, and you will pay taxes later, when you take the money out. (There is the exception for tax-deferred IRAs that you make non-deductible contributions to. Can we mostly ignore this for the purposes of this blog post, please? They’re helpful when making backdoor a Roth IRA contribution.)
- Roth: You get no tax break now, meaning the money you put it in is after-tax. Once the money is in there, it’s never taxed again.
A Roth conversion is when you take money out of the tax-deferred account (IRA or 401(k)) and move it into a Roth account (IRA or 401(k)).
Because the money you’re converting is money you haven’t paid taxes on, and you’re moving it to an account that contains after-tax money, you pay ordinary income tax on the amount you’ve converted, just as if you’d earned that amount of money as a salary.
Keep in mind that you can choose to convert just some of your pre-tax dollars each year. If you convert all your pre-tax dollars, you might push yourself into a higher tax bracket, which reduces the long-term tax benefits. You can instead spread out the conversion over multiple years.
To review:
- You move the money from your tax-deferred account into your Roth account.
- You pay ordinary income tax on that money.
- That money is forever more tax-free (barring Congress changing the rules, which most sane thought leaders in my profession think is vanishingly unlikely).
Why Would You Do That?
One of the most important rules in tax planning is to pay tax on your income at the lowest tax rate possible. Mind-blowing, I know.
As “duh” as this rule is, keeping it in mind can help you understand most tax strategies way more easily.
And a Roth conversion is one such tax strategy. You do a Roth conversion in order to pay a lower tax rate on the same dollar of income.
How exactly does that happen?
For easy illustration’s sake, let’s pretend that we know you’ll be at a 0% tax bracket this year, and we know you’ll be at a 20% tax bracket in the future. Doing a Roth conversion now means you pay $0 in taxes right now and the money is forever more tax-free. Not doing a Roth conversion now means that when you withdraw your money in the future, you’ll have to pay 20% of it to the government.
If we knew that our future tax rates would be higher than our current tax rate, then doing a Roth conversion would be a no-brainer. But while we can know what our current tax rate is, we can’t know what our future tax rates will be. Our personal financial circumstances can change, and also the tax brackets and other tax laws can change.
This means we have to do Roth conversions when we’re “pretty sure” that our current tax rate is lower than what our future tax rates will be.
Other Benefits of Converting Money to a Roth Account
There are several meaningful benefits to having money in a Roth account instead of a tax-deferred account beyond the straightforward “I don’t pay taxes on the money when I take it out of the account”:
- Roth accounts do not have Required Minimum Distributions. If you have money in a tax-deferred account, the government requires that you start taking it out when you turn 73 ½. There are no RMDs for Roth accounts. Keeping money in the account (if you can afford to) has many benefits for both you and your possible heirs.
- A big part of retirement planning when you’re in your 60s and beyond is managing how much of your income is taxable. This can affect how much you pay for Medicare, how much of your Social Security retirement income is subject to tax, etc. If you have money in a Roth account, you can choose to take that income without adding to your taxable income.
- If your heirs inherit the Roth account, they won’t need to pay taxes on the money when they take it out of the account.
Look for These Roth-Conversion Opportunities
If we harken back to the idea above that tax planning is all about paying income tax at the lowest tax rate possible, then below are some situations in which Roth conversions might be a good idea for you.
You’re Making Way Less Income This Year than Normal
The usual way we planners talk about Roth conversions is as follows:
“After you retire, and you stop earning that income, but before you start claiming Social Security, probably at age 70, you’ll have some relatively low-income years. Those are great years to consider Roth conversions because your tax rate will be lower than it has been and lower than it will be once Social Security benefits start.”
And that’s right! It’s just not…particularly interesting if you’re currently 30 or 40 or even 50.
But the essence of that advice does apply to you now. The essence is:
Look for your years when your income is temporarily low. That means your tax rate will be temporarily low. And that means Roth conversions are more likely to be a good idea for you.
How might this occur?
- You got laid off and couldn’t find your way back to a new job very quickly.
- You left your career for a while to go back to school.
- You’re taking an intentional sabbatical.
- You’re taking unpaid time off to raise kids or do other care-giving.
You Live in an Income-Tax-Free State and Could Move to a State with an Income Tax in Retirement.
I live in Washington state. There is no income-tax here. (It’s not all it’s cracked up to be. The state government has to find its money somewhere and so the overall tax system can be complicated and sometimes schools don’t get fully funded.)
If I was pretty sure I would move to California later in life, where my state income tax rate would be 9.3% and up, I might benefit from paying taxes now (because I’ll pay only federal income taxes) and avoid paying a 9.3% state income tax later.
You Bet the Federal Government Will Raise Tax Rates
This is a tricky situation, because lots of people make lots of reasonable, even “obvious” predictions about what will happen in the market or economy or the FEderal Reserve or the tax code or tax brackets…and it doesn’t happen.
But if you really believe that the federal government cannot help but raise tax rates later, that’d suggest you should do Roth conversions now, at a lower tax rate.
You Plan to Make a Big Charitable Contribution
Just as doing a Roth conversion adds to your taxable income, giving money to charity (if it’s enough to exceed your standard deduction) reduces your taxable income.
So, you can pair those two acts together in the same tax year to keep the tax rate on your Roth conversion down.
When to NOT do a Roth Conversion
In general, you should not do a Roth conversion if you expect the future tax rate on this money to be lower than your current income tax rate. That means if the opposite of the above circumstances exist—you will have more taxable income than usual this year, you plan to move from a high-tax to a low-tax state, or you think tax rates will fall—you should likely not do a Roth conversion.
Here are some other circumstances that argue against Roth conversions.
You Intend to Give Away Money to Charity
Giving away money from your tax-deferred accounts is one of the most efficient ways to do so.
- While you’re living, once you turn 70 ½, you can give money to charity directly from your tax-deferred account and you avoid the tax on it and the charity gets the full amount. (This is called a Qualified Charitable Distribution.) Until that age, yes, you’re going to be giving money to charity from either your income or your taxable investment accounts.
- When you die, you can leave your tax-deferred account to a charity. They get the full amount of money (they don’t pay taxes). Your heirs can inherit other, more tax-favorable buckets of money.
If you intend to give the money in your tax-deferred accounts to charity anyways, there’s no need to convert the money to Roth accounts now. The whole point of Roth conversions is to avoid taxes in the future. But a charitable contribution already accomplishes this!
You Don’t Have the Cash to Pay the Taxes
When you do the conversion, you have to pay taxes on the money you converted. (To be clear, you have to pay taxes on all the pre-tax money you converted. If you have money in your tax-deferred IRA that comes from after-tax contributions—contributions you didn’t get a tax deduction for—you don’t have to pay tax to convert those dollars. This is at the core of backdoor Roth IRA contribution strategy.)
The conversion is worthwhile when you put all the money you take out into the Roth account. That means the dollars to pay the tax bill shouldn’t come from this converted money, which means you have to have money in cash or taxable investments to pay the taxes.
If you don’t have that “outside” money, you probably shouldn’t do the conversion.
And remember, you can convert some tax-deferred money, maybe just as much as you have the extra cash to pay the taxes on.
You need the converted Money within Five years
If you’re in your 20s through 40s, it’s less likely that you’ll need this money in the short term, than if you are older and close to or in a traditional retirement. That said, you still might need this money (home down payment, anyone?), so you need to be aware of this restriction.
In short, you cannot withdraw this converted money within five years of the conversion without paying taxes and penalties. You’re really really best off converting and letting the money sit for five years or more. You can learn way more details about this five-year rule here. It actually gets pretty finicky.
Saving enough, investing (in a low-cost, diversified, appropriately growth-oriented way), and protecting yourself and your family (with insurance and estate planning) are the “cake” of financial planning when you’re in your 20s through 40s. Roth conversions are icing on that cake.
But if you have (and not until you have) fully baked that cake (have I tortured this metaphor enough?), Roth conversions can make Future You much better off financially, and I encourage you to look into it.
Are you looking for a financial planner who can explain some of these more arcane financial topics and help save you taxes over your lifetime? Reach out and schedule a free consultation or send us an email.
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