Here are some practical “how tos” when it comes to the much-discussed Roth conversion.
A Roth conversion is moving funds from a traditional pretax retirement account to a Roth after tax retirement account. It sounds simple, but there are many questions around the practical how tos.
How should I decide if a Roth Conversion is right for me?
The markets are down in 2022 and many folks may be wondering if now is a good time to convert their traditional IRA funds to a Roth IRA.
One basic question to ask is…
Do you expect your taxes in retirement to be more, less or the same as your taxes now?
For some of my clients in their prime earning years, they are already in some of the higher tax brackets for example 32%. But what if you recently took time off for the arrival of a baby, or were laid off for a period of time this year? This might be a good year for you to consider a Roth conversion because you may be in a lower marginal tax bracket than you will be in the future.
What are the potential benefits of a Roth conversion?
One benefit of a conversion is that you won’t have to pay taxes on any qualified distributions. The IRS (link opens in new tab) has a specific definition of qualified distribution, but very broadly this means withdrawals after age 59.5, and some other exceptions. Another benefit is that you won’t have a required minimum withdrawal at age 72 like traditional IRAs do.
Back to taxes…
Roth conversions can be expensive during your earning years because you need to pay taxes on the full conversion at whatever your marginal tax rate is. In 2022, for example, if you’re married filing jointly, the 24% marginal tax bracket goes from $178,151-$340,100. Say your taxable income is $185,000. You could potentially convert $155,100 ($340,100-$185,000) without pushing any income into the next marginal tax rate of 32%. So in this case, if you’re already in the 24% tax bracket, then it might be worthwhile for you to do.
You’ll owe taxes on the converted amount
Say you decide to convert $20,000 of pretax IRA funds to a Roth. You will owe ordinary income taxes on the amount you convert. The $20,000 gets added to your taxable income for the year and is taxed at your highest marginal tax rate. In the above example, say that’s 24%. That means you will owe an extra $4,800 ($20,000 x 24%) in federal income taxes. You may also owe state taxes depending on your state.
Here’s the important thing, though, about the taxes you owe on the converted amount.
Don’t pay the $4,800 owed from the funds in your pretax IRA account. Don’t withhold any money from your conversion for taxes. Instead, pay these taxes out of cash you have already. Don’t have the cash to pay the taxes? Then a Roth conversion may not be a great idea for you.
This is because if you withhold taxes from your IRA conversion, then you will also owe a 10% penalty on that money because the amount you’ve withheld for taxes is treated as a withdrawal, not as a conversion. (This assumes you’re under 59.5.)
Keep in mind that your individual situation will vary, and this is not intended as tax advice or as a personal recommendation. Talk to your financial adviser and tax professional for information on your personal situation.
How can I implement a Roth conversion?
Most custodians make a Roth conversion a relatively simple process that can be completed online if you already have both a pretax and a Roth IRA at that custodian.
Log into your pretax account online. Go to the section of the website for money movement, which could be called Transfers or Withdrawals/Deposits. Look for the option to transfer funds between accounts, and choose your Roth IRA account. Some custodians may even have an option called Roth Conversion. Select the dollar amount you want to convert. Don’t withhold any taxes (remember, pay these separately). Initiate the transfer. You should see the money movement into the Roth account within a day or two, depending on your custodian.
Then, pay the amount of taxes you owe. This can be done by logging into irs.gov and paying an estimated tax amount.