Just like that it’s October and we’re done with the third quarter. It was raucous at times but ended well for most investors. I’ll send out my Quarterly Update letter next Tuesday instead of today so we can stay on track with our theme of financial decisions that have a year-end deadline.
This week let’s discuss Roth conversions. You can do as many of these as you like within the year but they must be completed by December 31st to count for 2024.
Conversions happen when you have money in a tax-deferred retirement account like a Traditional IRA or 401(k) and move a portion or the whole thing to a Roth IRA. Why would you want to consider doing this? You’re already saving for retirement, so that’s good. Beyond that, it’s all about taxes and when you pay them.
Your typical retirement account is tax-deferred, meaning the government gives you a tax deduction when you contribute and they’ll wait until you withdraw money before taxing you. That could be a while, maybe decades. In a sense, the government is making an investment because by forgoing income taxes on your initial $1,000 contribution, they could ultimately get to tax an account valued at maybe ten times that.
You can get around this future tax issue in two fundamental ways. One is to skip contributing to a Traditional IRA in the first place and contribute to a Roth instead. You’ll give up the near-term tax benefit in exchange for growth that would be tax free in retirement. This method works great the younger you are. Unless you’re in a higher federal tax bracket, say 24% or more, you should strongly consider only contributing to a Roth IRA and Roth 401(k), assuming your workplace offers the latter. Take the pain now and enjoy the benefits later.
The second way is to force money into a Roth via conversion. Here are some considerations.
- Is this a low taxable income year? Maybe you’ve had tax losses or started a business, had large deductible medical expenses, or anything that artificially lowers your taxable income. Maybe you retired early and aren’t taking Social Security yet. A yes to any of this (and other reasons – these are just some of the big ones) means you are a candidate for a Roth conversion.
- Conversions aren’t contributions so income limitations don’t apply.
- Roth conversions add to your taxable income in the year you do them so making educated guesses about your place in the federal tax brackets is critical.
- There is no minimum amount for a conversion, so try to stay within the relevant tax brackets.
- You can Google the brackets but the 22% bracket for Married Filing Jointly goes from about $94,000 to $201,000. Try to stay within that bracket or lower for Roth conversions. Paying proportionally more tax than that makes it harder to break even.
- Breaking even on the conversion deals with the size of the tax bill and how long you have to grow money in the Roth.
- Plan to pay the tax from cash in the bank since paying from your IRA also makes it harder to break even.
- Once your money is in your Roth you can grow it until age 59 ½ when you’re allowed to withdraw penalty-free. But you can grow for longer, maybe your whole life.
- You’ve already paid tax on your conversion so those specific dollars won’t be taxable again. Any gains in your account wouldn’t be taxed either unless you break the rules. One rule is that each conversion has to remain in the account for five years to be tax free. It might make sense to open individual accounts for each year’s conversion to help with bookkeeping if you think you might need to break into the conversion early.
- Investment options are the same whether money is in a Traditional IRA or a Roth.
- The conversion shouldn’t cost anything. You can move existing investments or cash from your IRA to a Roth. Moving investments is less precise because your custodian might take a few days to process the conversion so you won’t know the exact dollar amount until after the conversion happens. This is why I favor moving cash. I suggest you do so assuming you don’t have transaction costs to sell and repurchase investments. Ask your custodian about this.
- While conversions typically take a few days to process, custodians get backed up as year-end approaches. Procrastinators should try to make December 15th their deadline.
- Under current tax rules you won’t be required to take RMDs from your Roth. This is huge for people who start converting to Roth early because it buys down future RMDs when your tax rates are (hopefully) lower. Still, weigh your options because future RMDs may not be a big enough issue to warrant paying taxes on Roth conversions.
- Roth conversions can be like prepaying taxes for beneficiaries. Sometimes that’s reason enough to convert to Roth. Again, weigh your options.
So those are some situational questions and considerations dealing with converting some or all of your traditional retirement money into a Roth. This sounds great, and I suppose it is, but it’s not necessarily for everyone. Do your homework and get good advice so you can hopefully avoid stepping on any retirement savings landmines.
Have questions? Ask us. We can help.
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