The Best Times to Do a Roth Conversion
Roth IRA conversions have become an increasingly popular tool for savvy investors and retirees looking to optimize their retirement plans. By converting assets from a traditional IRA or 401(k) into a Roth IRA, you pay taxes now in exchange for tax-free growth and withdrawals later. However, the timing of a Roth conversion is critical to ensuring you reap the maximum benefit while minimizing taxes and penalties.
Over the years, I have advised many clients on Roth conversions and run many tax projections to model out the impacts of a Roth conversion on a client’s tax return. In addition, we have often incorporated Roth conversion strategies into long-term financial planning models to see the impact over the longer-term. With that in mind, I have noticed three specific circumstances which often argue for a Roth conversion. However, because each person’s specific circumstances are different, I urge the reader to work with a qualified professional before making these types of important financial decisions.
In this article, we’ll explore three optimal times to perform a Roth conversion:
- After Retirement but Before Taking Social Security and Medicare
- During a Bear Market
- As an Estate Planning Technique
Early Retirement (Before Social Security and Medicare)
For many retirees, the years between leaving the workforce and starting Social Security and Medicare represent a unique window of opportunity for Roth conversions. During this time, your taxable income is often lower, allowing you to stay within a favorable tax bracket while converting assets.
Why Timing Matters
Roth conversions increase your taxable income for the year in which they’re completed. If done carelessly, the conversion amount could push you into a higher tax bracket, resulting in more taxes owed. Additionally, converting too much could increase your Medicare premiums due to the Income-Related Monthly Adjustment Amount (IRMAA) and trigger taxes on up to 85% of your Social Security benefits. I often hear investors focusing too much on the tax-free growth aspect of Roth conversions and not on the tax rate they are paying today. If the tax bracket is too high, you sacrifice the potential compound interest on the check you wrote to Uncle Sam, thus mitigating your long-term benefits.
The Optimal Strategy
- Control Your Tax Bracket: Calculate how much you can convert without bumping into the next tax bracket. Note that if you are itemizing, your deductions could go down as your AGI (adjusted gross income) increases due to the roth conversion.
- Monitor IRMAA Thresholds: In 2024, IRMAA thresholds start at $97,000 for single filers and $194,000 for married couples filing jointly. Staying below these thresholds will keep your Medicare premiums lower while on the program.
- Avoid Additional Taxation on Social Security: Once you start taking Social Security, any increase in adjusted gross income (AGI) could subject more of your benefits to income taxes. By performing conversions beforehand, you minimize this risk.
During a Bear Market
A bear market—when stock prices fall and market sentiment is pessimistic—can feel unnerving. But for those considering a Roth conversion, it can actually present an advantageous opportunity.
Why a Bear Market is Beneficial
The primary reason to convert during a market downturn is simple: you’ll pay taxes on a lower portfolio value. When the market eventually recovers, all the gains on the assets in the Roth IRA will be tax-free, creating significant long-term benefits.
An Example
Imagine you own $100,000 worth of investments in a traditional IRA. During a bear market, the value drops to $75,000. If you convert to a Roth IRA at this lower value, you’ll pay taxes on $75,000 instead of $100,000. When the market rebounds, the growth on that $75,000—now tax-free—will substantially enhance your retirement savings.
How to Capitalize
- Convert in Installments: Bear markets can last months or even years. Instead of converting your entire IRA in one go, consider smaller conversions to spread out the tax burden over multiple years.
- Reallocate Post-Conversion: After converting, review your investment strategy within the Roth IRA. Growth-oriented investments are often ideal since their future gains will not be taxed.
As an Estate Planning Technique
Roth conversions can also serve as a strategic estate planning tool. For many high-net-worth individuals, prepaying taxes on retirement accounts through a Roth conversion helps reduce the tax burden on heirs while maximizing the inheritance they receive.
Why Roth IRAs Benefit Heirs
Traditional IRAs inherited by non-spouses are subject to the SECURE Act’s requirement that the account be emptied within 10 years. Distributions during this period are taxed as ordinary income, which could push your heirs into a higher tax bracket.
Roth IRAs, however, are not subject to income tax upon withdrawal, even under the 10-year rule. This allows your heirs to maximize their inheritance without worrying about taxes.
Key Considerations
- Gift Taxes vs. Roth Conversion: When prepaying taxes via a Roth conversion, you’re essentially making a gift to your heirs. The beauty of this strategy is that it doesn’t trigger gift taxes, allowing you to pass on more wealth tax-efficiently.
- Balance Lifetime Tax Strategy: While converting helps your heirs, it’s essential to consider your own financial needs and tax implications. Work with a financial advisor to strike the right balance between your current tax obligations and your estate goals.
Frequently Asked Questions
Is a Roth Conversion Right for Everyone?
No. Generally speaking, Roth conversions work best for those who expect to be in a higher tax bracket later than they are now or those who wish to leave a tax-free inheritance. If you’re already in a high tax bracket and expect to be in a lower bracket later, it may not make sense to convert.
How Do Roth Conversions Impact Required Minimum Distributions (RMDs)?
Roth IRAs are not subject to RMDs during the account holder’s lifetime. This is a major advantage over traditional IRAs and 401(k)s, where RMDs can force you to take taxable distributions even if you don’t need the income. It allows compound interest to work its magic for the remainder of the owner’s life as well as 10 years post-death.
Can I Undo a Roth Conversion?
Unfortunately, as of 2018, Roth conversions are permanent due to changes in tax laws. Careful planning is essential before executing a conversion.
Conclusion
Timing a Roth conversion correctly can have a profound impact on your financial future and the legacy you leave for your heirs. In my experience, the three best times to consider a Roth conversion are:
- In early retirement (before taking Social Security and Medicare) to avoid increased taxes and premiums.
- During a bear market to take advantage of lower portfolio values and tax-free growth.
- As an estate planning technique to prepay taxes for your heirs and maximize their inheritance.
Each of these strategies requires careful consideration of your current tax situation, future goals, and potential legislative changes. Consulting with a CERTIFIED FINANCIAL PLANNING professional is crucial to ensure you’re making the most of this powerful retirement planning tool.
