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Four Times You Should Consider a Roth Conversion

September 14, 2020

A traditional IRA is a fantastic retirement savings tool because you can minimize your current tax burden and pay taxes on your contributions later. There are some instances, though, when you may want to take care of what you owe the government now so that you can avoid subsequent taxes down the road. To accomplish this goal, you’ll want to convert some of your traditional IRA balance to a Roth as Roth IRA distributions in the future including all the gains will be income tax-free.

When might a Roth conversion make sense? Although you should always consider your unique financial planning needs, there are four scenarios in which it makes sense to consider a Roth conversion.

Scenario #1: When Youth is on Your Side

When you’re younger and not yet as established in your career, chances are you’re earning less than you will be in the future. This means you’re likely in a lower tax bracket than you will be in years to come. If you convert to a Roth now, you can pay taxes at what is likely to be a lower rate than when you reach a higher tax bracket later. Plus, converting to a Roth when you’re younger means you can take advantage of the magic of compounding to grow your savings further.  For example, if you have a 401(k) plan balance with your last employer, you can rollover it over to a traditional IRA account without paying income taxes.  Then you can decide if you want to convert some or all of the IRA balance to a Roth IRA by paying income taxes on the conversion amount if you haven’t mixed after-tax contributions with the pre-tax contributions. 

Before 2010, only taxpayers who earned an adjusted gross income of less than $100,000 were allowed to convert any IRA balance to a Roth IRA.  Since 2010, the IRS has allowed many individuals to convert their traditional IRA to Roth IRA regardless of income level.    

Scenario #2: When You Face a Decrease in Income

An unexpected dip in income may not feel like a positive thing, but a Roth conversion gives you a chance to see the silver lining. Converting in a year where you drop to a lower tax bracket means paying less in taxes on the conversion. For example, if you convert $50,000 from a traditional IRA to a Roth and you fall in the 24 percent federal marginal tax bracket, you’ll pay the IRS $12,000. However, if your income decreases and you land in the 12 percent federal marginal tax bracket instead, a conversion of $50,000 would only cost you $6,000 in federal taxes.  Many people face a decrease in earned income this year due to the pandemic and economic recession.  For the people who have more than enough in their emergency fund, and have enough money to pay income taxes on the Roth conversion, it’s the perfect time to make lemonade out of the lemons. 

SEE ALSO: Understanding the ‘Rich Person Roth’


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