The joke works best in person, but maybe you’ve heard it: One guy says to another, “What’s the key to great comedy?” And while the second guy is opening his mouth to say, “I don’t know,” the first guy interrupts with “Timing!”
It is a fact that timing is important in many aspects of life. It’s also true that many people preparing for retirement are discovering the advantages of Roth accounts for their retirement savings. You probably remember that, unlike traditional IRAs, 401(k)s, and 403(b)s, Roth accounts are funded with after-tax dollars, meaning that you don’t get to reduce your taxable income by the amount of the contribution, as with traditional accounts. However, one of the principal attractions of Roth accounts is that, also unlike traditional retirement accounts, the funds withdrawn from Roth accounts in retirement are not counted as taxable income for most taxpayers. The other benefit of Roth accounts that appeals to many is that they have no annual required minimum distributions (RMDs), which means that the owner has more control over when money comes out of the account.
Are There Income and Tax Considerations for a Roth Conversion?
Because of these advantages, some taxpayers can benefit by converting traditional accounts to Roth accounts. But, because Roth conversions create taxable events (the transferred amounts must be converted from pre-tax to after-tax, which means paying taxes on the amount transferred), timing is very important. On the other hand, a Roth conversion can be a great way to create more tax-free income in retirement, even for those whose income may prevent them from contributing directly to a Roth IRA (employer plans like 401(k)s and 403(b)s are generally exempt from such income restrictions for contributors).
What’s the Best Time to Consider a Roth Conversion?
To get the maximum benefit from a Roth conversion, then, it’s best to take advantage of periods when you may be in a lower tax bracket, because your tax bracket at the time of the transfer determines how much you will pay on the conversion. This means that when you’re considering a traditional-to-Roth conversion, you need to consult with your tax and financial advisors and do a careful tax bracket analysis to make sure the conversion makes sense, both in terms of your current tax situation and for efficient retirement income planning.
Several things should be considered. First, remember that any amounts converted from a traditional account to a Roth account will be considered as taxable income. So, if your income before the conversion is close to moving you into a higher bracket, the conversion could push you over the line, creating extra tax liability. In such a case, you may not wish to convert the full amount of the traditional account in a single year, thus limiting your tax liability. By spreading the conversion out over several years, you may be able to pay less in taxes and, at the same time, create a larger tax-free income stream in retirement.
Another factor to consider is market pricing. In years when the market has been difficult, you are likely to have fewer capital gains to report. This can put you in a lower overall tax bracket, possibly creating an opening for paying less in taxes on a Roth conversion and setting up the converted funds for tax-free growth when markets are more favorable.
Roth Funds and Taxes: “Pay Me Now or Pay Me Later?”
The other consideration is whether you are more likely to be in a higher or lower tax bracket in retirement. Some retirees who have pension and Social Security income, investment income, and RMDs from traditional retirement plans can actually find themselves in a higher tax bracket than when they were actively employed. For them, converting traditional to Roth funds can reduce the amount of taxable income they receive in retirement and help to keep them in a lower tax bracket. Remember: Roth accounts have no RMDs, so if you don’t really need the income in retirement, you can simply leave the money in the Roth account and allow it to grow and compound tax-free until it is needed, either by you or by the account’s beneficiary.
Roth Conversion: Tips to Remember
- Traditional 401(k) or 403(b) conversions usually involve a rollover to a Roth IRA account, which typically can only occur when you are retired or at retirement age. Taxes will usually apply to the converted amount.
- A five-year holding period applies to withdrawing funds converted to a Roth account. Converted funds withdrawn earlier than five years from the date of conversion are treated as taxable income, which cancels out a principal benefit of the conversion.
- If you withdraw money from a traditional IRA for a Roth conversion before age 59 ½, you may owe a 10% tax penalty on the withdrawn amount.
Your Mathis advisor can work with you to determine whether a Roth conversion would be beneficial. If you’d like to know more, please get in touch with us; we’re here to provide the answers you need.
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