Retirement

When to Convert to a Roth IRA

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Retiring early can be a wonderful achievement. But it takes a lot of planning and a lot of saving to do it. If you are one of the lucky ones who can retire before age 60, odds are that you have a large 401(k) balance that has made this possible.

Most people that retire early with a large 401(k) or traditional IRA balance don’t know that this is a great time to convert this money to a Roth IRA

Roth IRAs have the benefit of not being taxable when the money is withdrawn. The downside is that you don’t get to contribute the money pre-tax like you do when contributing to a traditional IRA or 401(k) plan. 

The Best Time to Convert to a Roth IRA

We hear a lot about how converting to a Roth IRA can be a great idea, but we rarely see good advice on the best time to do it. A Roth IRA conversion is not for everybody. In fact it’s not even for the majority of people. A Roth IRA conversion usually only makes sense if your income tax rate is lower today than it will be in retirement.


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Believe it or not, many people who retire early have a federal income tax rate of 10% or less. For some the federal tax rate is actually 0%. This is because these people generally have very little income. There is no more salary income and Social Security benefits haven’t begun yet. If there are no pension payments driving up income, it’s very possible to have a federal income tax rate of 0% at that time.

A low income tax rate means a Roth IRA conversion could be a great idea. The money that is converted to the Roth IRA will not be taxed when it’s withdrawn. This is in stark contrast to withdrawals from a 401(k) plan or traditional IRA, which are taxed at ordinary income tax rates. Not only are the withdrawals taxed, but you are forced to withdraw from these accounts annually at age 72. These withdrawals are called Required Minimum Distributions (RMDs) and are the source of huge tax bills for many people in retirement. It is also important to point out that Roth IRAs do not have RMDs.

A Case Study

Most people use a financial planner to help them figure out if a Roth IRA conversion makes sense for them and to determine how much they should convert. This can be a great idea since mistakes can lead to missing out on thousands of dollars in potential savings.

For a Roth IRA conversion case study that I look at, I used WealthTrace’s retirement planning software. WealthTrace has a comprehensive Roth IRA conversion scenarios feature that allowed me to see if a couple should convert to a Roth IRA, how much they should convert, and over what time frame.

The couple I looked at is 58 years old and just retired. They have $1 million in a rollover IRA and are thinking of converting it to a Roth IRA. They will both receive Social Security at age 67. The prime Roth conversion years are today through age 66 (before Social Security begins).

I homed in on the best solution using the Roth conversion what-if scenarios feature. It turns out that they should convert 60% of their rollover IRA to the Roth IRA over a six year period. This gives them the most money left over at the end of their life expectancy.

One might ask, why not convert all of the money to a Roth IRA? This is not always the best strategy because federal income tax rates (and some state income tax rates) are progressive in nature. So the more income you have, the higher your tax rate is. If you convert too much of the IRA in one year, this will drive you into a tax rate that is so high that the benefits of the Roth conversion go away or are at least severely reduced.

Other Reasons to Consider a Roth IRA Conversion

Many people like having a Roth IRA for inheritance purposes. A Roth IRA left to children will not have RMDs and are not taxable. This is not true of traditional IRAs and 401(k) accounts. When these types of accounts are inherited by children, the children will be forced to take RMDs and will pay taxes on these withdrawals.

Another reason many people are converting to Roth IRAs is the belief that federal income tax rates are going to increase in the future. This is entirely possible given the deficits the U.S. is running and the staggering amount of debt our country has. If income tax rates will be higher in the future, it could make a lot of sense to convert to a Roth IRA now while federal income tax rates are relatively low.

In Summary

Converting to a Roth IRA can save many people a lot of money. For some it could mean an earlier retirement than they thought possible. But you should not guess or use simple free calculators when making this decision. Either hire a qualified financial planner to help or purchase sophisticated retirement planning software that will allow you to run your own Roth IRA conversion scenarios. 


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