Should I do Roth conversions?

It makes sense to convert pre-tax assets to Roth when you can do so at a lower tax rate than you would be at when required to take distributions from those pre-tax accounts. If you don’t have a significant amount of money in pre-tax accounts, or if your income tax rate in retirement will be at an all-time low, then it may not make sense to convert assets to Roth.

For those who do have a significant amount in pre-tax accounts or have windows of opportunity before distributions start (periods of being in a lower income tax bracket than in retirement), Roth conversions can be a great way to pay less in taxes and can save you tens or even hundreds of thousands of dollars.

How do you know whether or not you should do Roth conversions? First, estimate your taxable income in retirement and your highest marginal tax rate. If you project yourself to be in the 10% or 12% bracket in retirement, there isn’t really any room to convert assets to Roth since there aren’t any lower tax brackets. If you project yourself to be in the 22% bracket, 24% bracket, or higher, are there any years you will be taxed at a lower rate when you have little or no taxable income? If so, those could be great years to convert assets to Roth.

There are a few periods in life where you may have a greater chance to do Roth conversions. Before you begin RMDs or start taking Social Security is one. Your taxable income is lower during this period so it could naturally be an opportunity to convert assets to Roth. If you are able to live on taxable accounts for a period of time, this could be another great opportunity to convert pre-tax assets to Roth. Your taxable income could be $0 if you are retired and living on money from a taxable brokerage account, which has already been taxed. This gives you the chance to convert a substantial amount of assets to Roth at a 10% or 12% federal income tax rate.

You may have an opportunity to turn lemons into lemonade if you were to lose your job. This obviously decreases your income depending on how long you are out of work, but could be a chance to convert pre-tax assets to Roth at a lower tax rate. It is not unusual for the stock market to be down at the same time many Americans are losing their jobs, and converting when the market is down is a great way to get a “discount” on your Roth conversion.

How to do Roth conversions

There are no income limits on Roth conversions (which is what enables the backdoor Roth strategy) and no limits to the amount you can convert each year. In fact, you could convert your entire 401(k) to Roth in a single year even if it was millions of dollars (the IRS would probably prefer it this way since you would pay substantially more in taxes). Converting pre-tax assets to Roth is only a good strategy when you do it the correct, optimal way. Recklessly converting to Roth could end up causing more harm than good.

So what is the “correct” or optimal way? It generally means filling up your lower tax rate buckets with conversions, like your 10% and 12% bucket, but it may not be beneficial to convert at rates of 22%, 24%, or higher, depending on your expected tax rates in retirement. Remember, converting is only worth considering when you can pay a lower tax rate now than you would in retirement.

How you pay the taxes on your Roth conversion can have a big positive or negative impact on your strategy. Whenever possible, you should pay the conversion taxes with outside money, not the money that came out of your pre-tax account. Paying taxes from the funds you are converting means less money going into your Roth account, which means less tax-free growth over time. It could still make sense to do Roth conversions if you don’t have any extra money to pay the taxes, but whenever possible, you should always pay the conversion taxes with outside funds.

There are a couple major mistakes people make when doing Roth conversions. The first is violating the five-year rule and subjecting themselves to unnecessary penalties or taxes. The rules are a bit different depending on your age. If you are younger than 59.5, you must hold the converted principal for five or more years or be subject to a 10% penalty. Any earnings are automatically subject to a 10% penalty and taxes if you withdraw before 59.5, so make sure not to touch those.

If you are older than 59.5, you can take principal or earnings out at any time with no penalty. However, you must wait five years from when you made your first Roth IRA contribution or conversion to withdraw earnings or those will be taxed.

The other big mistake often made when doing Roth conversions is not reconsidering asset allocation. The type of assets you invest in inside of a pre-tax account are substantially different from the optimal investments inside of a Roth account. Since Roth accounts grow tax-free and qualified distributions are entirely tax-free, you want assets that have the most potential for growth inside of your Roth accounts. This doesn’t mean you should change your overall allocation to be riskier, but you should consider shifting risk around to take more in your Roth account and less in other parts of your portfolio.

Converting pre-tax assets to Roth accounts can potentially save you six figures in taxes, but it is only beneficial if you do it the right way. If done incorrectly, Roth conversions could end up causing you to pay more in taxes. Make sure you are always converting at a lower tax rate than you expect to be at in retirement. Whenever possible, pay the conversion taxes with outside money so the full conversion amount goes in your Roth. Know the ins and outs of the five-year rule so you don’t pay any unnecessary penalties or taxes. Reassess your asset allocation after converting and make changes as necessary. If you can do all of that, you can save money on taxes and take larger distributions from tax-free accounts in retirement.

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