Roth conversions are a common strategy in retirement planning that allows you to move money saved on a pre-tax basis (such as a traditional IRA or 401k) to a Roth IRA.
The benefit of doing this is that a Roth IRA grows tax-free and withdrawals in retirement are also tax-free, as long as you’ve met the holding period.
However, when you do a Roth conversion, you pay income taxes on the amount that you convert at your current tax rate, which can be expensive.
When Does a Roth Conversion Make Sense?
The decision to convert to a Roth IRA should be carefully considered, as it may not always make sense from a tax standpoint. There are, however, several reasons why a Roth conversion can be beneficial, including:
Reducing Taxes in Retirement
Paying taxes upfront by converting to a Roth IRA can reduce your overall taxes in retirement.
For example, if a couple wants $7,000 monthly in net income and has an IRA worth $800,000 and a joint brokerage account worth $400,000, converting up to the lowest tax bracket may be the best option.
The cumulative taxes may be higher at first, but by age 85, there could be a $65,000 benefit to doing the conversion.
Anticipating Future Tax Hikes
If you believe that taxes will increase, a Roth conversion may be a good option to avoid paying higher taxes in retirement.
With the expiration of the Trump tax cuts and the current administration’s proposal to raise taxes, many people are starting to consider this option.
Estate Planning Considerations
Finally, Roth conversions can also be a helpful estate planning tool. By converting to a Roth IRA, you can provide tax-free income for your beneficiaries, which can be particularly beneficial if they are in a higher tax bracket than you are.
Also, Roth IRAs are not subject to required minimum distributions (RMDs), allowing you to pass on more of your wealth to your heirs.
In Summary
Roth conversions can be a useful tool in retirement planning, but they may not always make sense from a tax standpoint.
However, if you are looking to reduce taxes in retirement, anticipate future tax hikes, or have estate planning considerations, a Roth conversion may be a good option to consider.
As with all financial decisions, it’s important to carefully consider your options and consult with a financial professional to determine the best course of action for your unique situation.
