Did you know if you have a Traditional IRA that it can be converted to a ROTH IRA? There are several considerations that need to be made to make sure this is the right time for you to take advantage.
At first glance it seems like a down market may be the best time to convert, but when analyzing the whole scenario, it may not make the difference initially identified. Josh and Ross love diving into the comparisons between first glance and the full picture, so here we go.
Let’s start here: What happens when you convert a Traditional IRA to a ROTH IRA? In the year of conversion, you pay all of the tax on the funds you elect to convert. Then, when you draw out of your retirement (assuming you have met all the other qualifications not discussed in this blog post) all the funds are tax free distributions. This is the biggest reason why people invest using the ROTH IRA. There are several others not discussed on this episode of the podcast including access to the funds for education, reduced Required Minimum Distributions (RMDs), but we’ll save that review for another time. We would hate to distract from the main point of this article; when should you convert from a Traditional IRA to a ROTH IRA.
As Ross discusses on the podcast, regardless of whether or not the current balance is down, the real deciding factor on the appropriateness of conversion timing is that your current marginal tax rate is lower than your retirement marginal tax rate. If your taxable income, married filing jointly, is between $178,151 & $340,100 in 2022, your marginal tax rate will be 24%. If you believe your tax rate will be less when you are ready to retire and draw on these funds either because A) your income in retirement will be less than $178,151, causing your marginal tax rate to fall to 22%, or B) your income will be more than $340,100, causing your marginal tax rate to rise to 32%, or C) you believe the federal government will increase the tax rate from 24% to something higher for taxable income in the same range. In scenario A, it would be best to pay tax at the lower rate in retirement years, or leave in a traditional IRA, and make deductible contributions to this IRA if allowed. But in scenarios B & C, it would be best to convert the funds in the comparatively lower tax situation, pay the tax on the conversion now and the tax free at distribution in retirement.
There are several situations when you might experience bracket variation causing you to move tax brackets either up or down. Self-employment and commission-based wages can have wild fluctuations of either increased or decreased taxable income from year to year, giving you multiple opportunities to evaluate a ROTH conversion. A year that includes new business venture is typically a year of foregone wages and deductible business losses, may bump you to a lower bracket than you expect in retirement. Also, the start of a new career usually comes with lower wage and earnings expectations, particularly if this field is unrelated or if this is your first career. This is why most of the financial planning literature recommends ROTH contributions or conversion for those under the age of 25. If any of these changes put you in a lower bracket than you expect to retire in, it's definitely time to evaluate a conversion.
Two special notes to add when making a Traditional IRA conversion to a ROTH IRA.
1. If you are not of qualified retirement age (59&1/2 years old), you will need an outside source of cash available to pay tax due. Taking the tax payment out of the Traditional IRA triggers a early distribution penalty of 10%, which could significantly eat into the savings you are planning to gain from the conversion in the first place.
2. If you have both Deductible and Nondeductible IRAs and you are considering only a partial conversion of these funds to ROTH accounts, know that your basis in the accounts will be split pro-rata based on the amount converted. This is highly technical and I would recommend reviewing this with both your tax professional and financial advisor.
Check out the conversation Josh and Ross have reviewing the analysis and thinking through several scenarios that help sort out the situation.
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Progress Over Perfection,
Josh & Ross