How to Make Sure Your Roth Conversion Doesn't Backfire
Key Points
A Roth conversion could set you up with tax-free retirement income.
It's also a good way to avoid required minimum distributions.
Before doing a Roth conversion, make sure you're not creating a tax bomb or costing yourself money needlessly.
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There's a big downside to having money in a traditional IRA or 401(k). Not only are distributions from these retirement plans taxable, but you'll eventually have to take funds out of your account even if you don't want to.
Once you turn 73 or 75, depending on the year you were born, required minimum distributions (RMDs) begin. Those could be a huge tax headache if they're substantial.
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For these reasons, you may want to consider doing a Roth conversion, which allows you to move funds from a traditional retirement account into a Roth IRA. From that point on, you get to enjoy tax-free gains in your account as well as tax-free withdrawals. And RMDs won't be an issue, since you won't have to take them.
But while a Roth conversion could be a smart strategy for minimizing future taxes, it could also backfire. Here's how to make sure that doesn't happen.
Do the tax savings math
A crucial step in the course of a Roth conversion is making sure it makes sense to begin with. If you'll be forced to convert your money at a higher tax rate than the rate you expect to pay on withdrawals, you're not doing yourself any favors.
For example, say you're still working part-time right now, so you're looking at converting at a 24% tax rate. If you don't expect your RMD tax rate to go above 22%, then you're basically paying the IRS extra for no good reason.
Don't convert too large a sum at once
Roth conversions trigger taxes the year you make them. For this reason, it's important to spread out a large conversion across multiple tax years.
If you cram a $1 million Roth conversion into a single calendar year, you'll pay a very high rate of tax on much of that conversion. Not only that, but if you're on Medicare or about to enroll, a huge Roth conversion could lead to surcharges on your premiums (known as income-related monthly adjustment amounts) two years down the line.
One strategy you may want to take is aiming to fill up lower tax brackets and cutting off conversions at that point each year. For example, if, based on your financial picture, you can convert up to $150,000 to a Roth IRA while staying in the 24% bracket, you may want to limit yourself to that sum and not go over.
All told, a Roth conversion could be a strategic financial move. But it could also end up being a big mistake. Run the numbers carefully so you don't regret a conversion after the fact.
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