Is a Roth Conversion a Good Idea?

When it comes to retirement planning, one question worth considering is whether it makes more sense to pay taxes on your savings now or later. The answer depends on several factors, including what you expect your income and tax situation to look like in the future.

If you anticipate being in a higher tax bracket down the road, a Roth conversion may be worth exploring. By moving funds from a traditional IRA to a Roth IRA, you generally pay taxes on the taxable amount converted today, allowing the money to grow tax-free and potentially be withdrawn tax-free in the future.

While that may sound appealing, there are a few important considerations to weigh before deciding whether it's the right approach for you.

1. Your Future Expectations

While you may expect higher tax rates in the future, if you also anticipate needing less income in retirement, a conversion may end up being a wash. Working with a financial planner to develop a cash flow plan can help you think through this decision. You'll also want to consider required minimum distributions (RMDs) and whether converting funds now could help reduce future withdrawals that might otherwise push you into a higher tax bracket.

2. The Beneficiaries on Your Account

If you plan to leave your account to a child or grandchild, you'll want to consider their tax situation as well. If they're in a lower tax bracket and expect to remain there, a conversion may not make sense. Conversely, if they're likely to be in a higher bracket, inheriting Roth assets instead of traditional IRA assets could be beneficial.

Similarly, if you plan to leave your IRA to a qualified charitable organization, a conversion may offer little advantage since the organization can generally receive those assets without paying income taxes. You may also want to consider Qualified Charitable Distributions during your lifetime, which can offer tax benefits while supporting causes that matter to you.

3. Your Time Horizon

How long you expect to leave your Roth account invested should also factor into your decision. The longer your time horizon, the more opportunity there may be for tax-free growth following a conversion.

It's also important to consider when you may need to access the money. Roth IRAs have specific five-year rules that can affect withdrawals of converted funds, depending on your age and circumstances.

4. Paying the Taxes

When you execute a Roth conversion, you generally owe income taxes on the taxable amount converted. That means you'll need to consider how you'll pay those taxes and whether you have sufficient cash available. The amount you'll owe depends on how much you convert, your other income, and your federal and state tax rates.

Finally, if you decide to move forward with this approach, it's important to be mindful of your current tax bracket. Because the taxable portion of a conversion counts toward your income for the year, converting a large amount could push some of that income into a higher bracket. Working with your financial planner and accountant can help you determine how much to convert and whether the timing makes sense for your circumstances.

Finding the Right Balance

A Roth conversion can be a valuable planning opportunity, but it isn't necessarily the right choice for everyone. There are times when paying taxes now makes sense, and others when waiting may be the better option. The important thing is to understand what you're gaining, what you're giving up, and how the decision fits with what you want to accomplish. Looking at those pieces together with your financial planner and tax professional can help you decide which approach makes the most sense for your circumstances.