1 Thing You Must Do Before a Roth IRA Conversion
Written by
Jordan Rosenfeld
Edited by
Molly Sullivan
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Preparing for retirement can require income and asset shuffling to make sure you have enough funds available and don’t bump yourself into a higher tax bracket.
One method for this is known as a Roth conversion. This is a strategy where investors transfer funds invested in pretax accounts like 401(k) plans into a Roth IRA, where the funds are not taxed on withdrawals.
This kind of transfer means investors pay taxes on the converted balance. While this can be a smart strategy in some cases, before doing this, there’s one important step you should take.
Know Your Rates
The most important factor in deciding whether you should do a Roth conversion is knowing what your marginal tax rate is versus your expected rate when you take out your funds in retirement.
“The marginal tax rate is what you make on the next dollar of income that you have,” according to Josh Kaplan, CFP, enrolled agent (EA) and financial advisor at Armstrong, Fleming and Moore.
He explained that if you were to get a raise, for example, “The marginal tax rate looks at how much you would pay in taxes on your additional income, while the effective tax rate looks at what the average tax rate you pay on all of your income.”
Why These Rates Are So Important
Understanding the marginal tax rate is important because the Roth conversion is taxable, Kaplan pointed out. “It’s a cost that most people pay out of pocket as opposed to using your IRA to do so, which can have negative consequences.”
One way to think about it is like buying gas on a road trip, Kaplan explained. While each gas station might advertise the same price for fuel, the total cost you pay will vary because of state taxes. What might cost you $40 to fill up your tank in one state, could cost you $45 in another.
“Thinking about that in the context of a Roth conversion, if someone estimates their tax cost based on the effective tax rate, this is likely lower than your marginal tax rate, and you’re going to receive a larger tax bill than you were expecting,” Kaplan said.
Roth Conversion Mistakes
It’s most important to remember that a Roth conversion adds taxable income to your tax return, as you are paying the tax now to make pretax money tax-free, said John Jones, a CFP with Heritage Financial. “This can push one into a higher marginal tax rate if they are not careful to calculate the marginal tax bracket breakpoints.”
Jones pointed out that the marginal tax rate jumps can be significant, depending on which leap you’re making, as they go from 12% to 22% and 24% to 32%.
He gave “a perfect example” of a client who did a Roth contribution for himself and his wife at a 22% marginal tax rate, “which was a big mistake because in the following year he is retiring and would be in the 12% tax bracket,” Jones said. “In this case, he essentially cost himself 10% extra because of the lack of advice.”
When Is It Worth Jumping To a New Tax Bracket?
There might be times, however, when it still makes sense to convert into a larger tax bracket, but Jones said, “Tax planning really is a balance between the individual’s current and future situation, current and future tax legislation, and balance between pretax, post-tax, and tax-free assets.”
A larger dollar amount Roth may be justified if the individual has a large concentration of pretax assets and the conversion is not overcompensating for the growth of the account. For example, he said, a $10,000 conversion is only 1% of a $1 million IRA, so only a drop in the bucket, Jones explained.
Kaplan said the key is to look at how much you would pay in taxes across your entire lifetime, and how making a Roth conversion would impact that. “If you expect to be a significantly higher tax bracket in the future, it may be worth moving up to a slightly higher tax bracket now.”
State taxes could be another reason to go for it. If you move from a state like Florida, where there are no income taxes, to California, where there can be significant income taxes, it may be cheaper to pay a little more in federal tax today.
Don’t Overly Simplify
Kaplan suggested the biggest mistake an investor can make is oversimplifying a Roth conversion and looking at just the marginal tax rate.
“While it’s important, there is a lot more to it than just that. It’s something that should be thought of as one piece in the overall puzzle that is your financial plan.”
While a Roth conversion may help you save some on taxes in the long run, for some, using your IRA to make charitable gifts can save even more. Also, the additional income from a Roth conversion can lead to other costs like net investment income tax or higher Medicare premiums.
The key for Roth conversions is to look at the long-term effects, Kaplan concluded. “They often work best when done over a period of time, which allows you to convert a larger sum, while reducing the shorter-term costs.”
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Sources
- Josh Kaplan, Armstrong, Fleming and Moore
- John Jones, Heritage Financial
