Lower income tax rates make this an attractive time to convert your traditional IRA into a Roth IRA. By converting, you’ll pay taxes on those funds now instead of at some future (likely higher) rate.
The main hurdle will be paying taxes owed. If you convert $50,000 from a traditional IRA to a Roth, your taxable income will increase by $50,000. If you’re in the 24% tax bracket, that amounts to $12,000 in taxes owed. That might feel like a hit now, but it could be a financially sound decision, particularly if you expect to be in a higher tax bracket later in life.
Remember, in a traditional IRA, the contributions you make are tax deductible, meaning you don’t pay taxes up front. But when it’s time to withdraw funds in retirement, those withdrawals will be taxed as income. With a Roth, the opposite occurs. Contributions to a Roth are made with after-tax dollars. At retirement, you can withdraw those funds tax free.
If you think that tax rates will not go any lower, meaning now might be the time to lock in your best possible rate.
To avoid taking the tax hit all at once, you might stagger the conversion over several years. Additionally, you should consider a strategy that allows you to convert as much as possible each year without bumping into a higher tax bracket.
Certain income limits apply for anyone who wants to contribute new money into a Roth, however, anyone can open a Roth and transfer their traditional IRA balances in.
Conversion may make sense if:
- You have wiggle room before you bump into a higher tax bracket.
- You believe your tax rate will be higher in the future.
- You don’t intend to withdraw funds from the Roth account for at least five years.
Some investors may want to wait until the end of the year to have a better understanding of market performance and their income tax burden before making the conversion. Be aware that, under the new law, Roth conversions can no longer be undone. Talk to an advisor for help in analyzing the tax advantages and optimal timing.