When Should You Perform a Roth IRA Conversion?

We often talk about Roth IRAs – and for good reason, as they are a great tool for tax-free earnings growth.  

Roth IRAs are primarily touted as savings vehicles for lower-income workers with a long investment horizon who expect to be in a higher tax bracket in retirement. However, since assets in a Roth IRA are not subject to probate and can be passed on to heirs tax-free, wealthier investors may also benefit.  

The Roth IRA didn’t exist before 1998, so if you’re already retired, chances are good that you may not even have one. But that doesn’t mean you can’t take advantage of the unique features of this kind of IRA. A backdoor conversion allows investors with traditional pretax IRAs to convert those funds to a Roth.  

Three Key Factors to Consider

If you’re thinking of doing a Roth IRA conversion, here are a few things to consider:

Your future tax rates.

If you think your tax rate will rise in the future, it may be worth it to convert your traditional IRA to a Roth IRA and pay those taxes upfront now.

When will you need to access these funds?

If you expect to live off your traditional IRA savings soon, you may want to hold off on that Roth conversion.

Your beneficiary’s future tax rates, if applicable.

This is a bigger consideration for older retirees. Still, if the person you have named as your beneficiary for your IRA expects to be in a higher tax bracket in the future, you may want to consider converting your traditional IRA to a Roth IRA now. This way, the assets will be inherited tax-free.  

Just keep in mind that you’ll have to foot the tax bill, so this is something that you’ll want to carefully consider before making any decisions. And if your beneficiary expects to be a in a lower tax bracket at the time of inheritance, then it may make more sense not to convert your traditional IRA instead.  

In any event, the IRS requires those subject to RMD rules (individuals 72 or older) first to take the RMD before any amount of their traditional IRA can be converted to a Roth IRA.  

Why You Should Perform a Roth IRA Conversion Sooner Than Later 

Even if you don’t think your income will increase enough to put you into a higher tax bracket, you should consider performing a conversion sooner than later.  

Many financial experts believe that the Tax Cuts and Jobs Act of 2017 (TCJA) reduced federal income tax rates to the lowest level they may ever be. Here are the rates for 2022: 

Tax Rate For Single Filers For Married Individuals Filing Joint Returns For Heads of Households
10% $0 to $10,275 $0 to $20,550 $0 to $14,650
12% $10,275 to $41,775 $20,550 to $83,550 $14,650 to $55,900
22% $41,775 to $89,075 $83,550 to $178,150 $55,900 to $89,050
24% $89,075 to $170,050 $178,150 to $340,100 $89,050 to $170,050
32% $170,050 to $215,950 $340,100 to $431,900 $170,050 to $215,950
35% $215,950 to $539,900 $431,900 to $647,850 $215,950 to $539,900
37% $539,900 or more $647,850 or more $539,900 or more

TCJA includes a sunset provision, and tax rates are scheduled to return to their pre-2018 amounts in 2026. But it’s possible that these tax rates will not make it that far.

If you’ve been thinking about doing a full or partial Roth IRA conversion, now is the time to take action. The year is almost over. That means you probably have a pretty good idea of your total annual income. This should help give you a clearer picture of how much of a conversion you can afford without crossing into a higher tax bracket.

Other Ways TCJA Made Roth Conversions More Attractive

You were in the 33% marginal tax bracket before TCJA was passed. But since 2018, you’ve shifted to the 24% tax bracket. If you were to do a Roth conversion this year, you’d pay less in federal income taxes on the amount you convert than you would have before TCJA.

That may sound great. But what if you’re trying to avoid taking a huge tax hit in a single year? No problem! Assuming the lower tax rates remain until 2026 as planned, you may choose to convert the smaller amount of your traditional IRA to a Roth IRA every year through 2025.

Here’s another example. You’re single and will earn about $125,000 this year. This would put you in the 24% tax bracket.

Now, let’s say you have $75,000 in a 401(k) plan with a former employer. If you converted all of it to a Roth IRA this year, you’d be taxed at the next higher marginal rate (32%) on nearly half of the conversion amount.

Instead, you could spread several smaller partial conversions over several tax years. If your income remains about the same each year, your Roth conversions would be taxed at the 24% marginal rate.

Another benefit of TCJA is that the width of some joint-return tax brackets has been doubled to twice the size of the single-filer bracket. Taxpayers in these brackets can now do Roth conversions on larger amounts without worrying about being pushed into a higher tax bracket. If you’re married and in the 22% or 24% marginal brackets, you should consider doing a Roth conversion before 2026.

There is one downside that TCJA brought for Roth conversions. Before 2018, Roth conversions could be reversed via a recharacterization. That’s no longer the case. If you’re wondering why anyone would want to do that, here’s the reason: if your account took a hit from a market decline, reversing your Roth conversion could help you avoid paying tax on money that was no longer there. But TCJA took this reversal option off the table.

Why 2022 Might Be the Right Time for You 

Besides tax rates, how do you know if 2021 is the best time for you to perform a Roth IRA conversion? Here are three scenarios:  

Your 2022 earnings will be lower than usual.   

If you’re still working and will fall into a lower tax bracket than normal, you may want to consider a Roth IRA conversion at your current lower tax rate.  

This scenario is most feasible for workers with variable income from year to year, such as commissions or bonuses.  

You’re retired but haven’t started taking Social Security benefits.  

You may find yourself in a lower-than-usual tax bracket in the year that you retire. Your earnings may be lower than normal during your retirement year, especially if you retire well before year-end. Your income will be further reduced if you choose to put off taking Social Security. And, if you delay taking it for a few years after you retire, you may have a considerable window of opportunity to do a series of Roth conversions while you remain in a low tax bracket.    

When you do start taking Social Security benefits, your income will rise. If you have a traditional IRA or 401(k), you’ll also see an increase in your income once you turn 72 and start taking required minimum distributions (RMDs) from those accounts.   

The benefit of doing a Roth IRA conversion during the window between retiring and drawing your Social Security benefit (which you must start doing by age 70) is that Roth IRAs aren’t subject to RMDs.   

One thing to remember is that RMDs may not be rolled over into a Roth IRA, and they must be distributed before doing a Roth IRA conversion once you reach age 72.  

You want to make charitable donations. 

If you want to donate appreciated assets, the tax deduction you get from it may be used to offset the tax you’ll owe on a Roth IRA conversion. However, you must be able to take an itemized deduction for your donation.   

Get professional assistance to decide when the time is right

Because of the potentially significant tax implications, deciding when to perform a Roth conversion should be part of a comprehensive financial plan. If not done properly, the tax hit from the conversion could offset the benefits. Get your plan started by requesting a free, no-obligation consultation with one of our advisors. 

Request a no-cost, no-obligation advisor consultation today!

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Alli Thomas

Alli Thomas has worked in the financial services industry for nearly 20 years, with a focus on retirement-related investing. She began her career as a FINRA-licensed participant-services call-center associate at Vanguard, and then moved to Principal Financial Group, where she worked closely with employers, assisting with retirement plan set-up and design, selecting appropriate plan investment offerings, and maximizing employee participation through targeted education campaigns and enrollment meetings. Alli has also worked as a qualified 401(k) administrator and registered investment advisor for several small investment firms. She now writes about all things investment- and finance-related, leveraging her extensive experience and passion for retirement planning to help investors make well-informed financial decisions.

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