Does a Roth IRA Conversion Make Sense for You?
When you convert from a traditional IRA to a Roth, there’s a tradeoff. You will face a tax bill—possibly a big one—as a result of the conversion, but you’ll be able to make tax-free withdrawals from the Roth account in the future.
One reason that a conversion might make sense is if you expect to be in a higher tax bracket after you retire than you are now. That might happen, for example, if your income is unusually low during a particular year (for example, you were furloughed or lost your job during the COVID-19 pandemic) or if the government raises tax rates substantially in the future.
Another reason that a Roth conversion might make sense is that Roths, unlike traditional IRAs, are not subject to Required Minimum Distributions (RMDs) after you reach age 72. So, if you’re fortunate enough not to need to take money from your Roth IRA, you can just let it continue to grow and leave it to your heirs to withdraw tax-free someday.
Moreover, you can continue to contribute to your Roth IRA regardless of your age, as long as you’re still earning eligible income. Since January 2020, you can also keep contributing to a traditional IRA (previously you had to stop at age 70½).
How Much Tax Will I Pay If I Convert My Traditional IRA to a Roth IRA?
Traditional IRAs are generally funded with pretax dollars; you pay income tax only when you withdraw (or convert) that money. Exactly how much tax you’ll pay to convert depends on your highest marginal tax bracket.
So, if you’re planning to convert a significant amount of money, it pays to calculate whether the conversion will push a portion of your income into a higher bracket.
For example, if you’re single, your income of up to $86,375 (in 2021) will be taxed at a rate no higher than 22%. Income between $86,376 and $164,925 will be taxed at 24%, and income between $164,966 and $209,425 will be taxed at 32%.
So if your regular income is $75,000 a year and you want to convert a $100,000 traditional IRA (for a total income of $175,000), you’d pay 22% on the first $11,375 of that money, 24% on the next $78,549, and 32% on the remaining $10,076.
If instead, you were to convert, say, $80,000 this year and the remaining $20,000 next year, you’d avoid the 32% bracket entirely and be taxed at a maximum rate of 24%.
Is There a Limit to How Much You Can Convert to a Roth IRA?
You can convert as much as you like from a traditional IRA to a Roth IRA, although it’s sometimes wise to spread these transfers out for tax purposes.
What Happens When You Convert to a Roth IRA?
In a nutshell, you pay taxes on the money you convert in order to secure tax-free withdrawals as well as several other benefits, including no required minimum distributions, in the future.
What Is the Downside of Converting From an IRA to a Roth IRA?
The most obvious downsides are the hit the conversion makes on your current tax bill—your IRA withdrawal amount counts as taxable income—and that any money you convert can’t be touched for at least five years—unless you pay a penalty.
The Bottom Line
Converting a traditional IRA or funds from a SEP IRA or SIMPLE plan to a Roth IRA can be a good choice if you expect to be in a higher tax bracket in your retirement years.
To eliminate as much tax as possible, it may be advisable to split conversions of large accounts over several years or wait until your income or market rates are low. Either way, converting your investments to a Roth allows your earnings to grow and be distributed Tax-Free, potentially saving you thousands of dollars in the long run.
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