5 Common Situations Where Roth Conversions May Make Sense
Roth conversions can be a powerful tool in retirement planning. By converting funds from a traditional IRA or 401(k) into a Roth IRA, you pay taxes upfront in exchange for tax-free growth and withdrawals later. A common rule of thumb between traditional and Roth IRAs, is to contribute to the Roth when you're in a lower tax bracket than you expect to be in the future. But when does it make sense to make conversions? Here are 5 scenarios where Roth conversions might be beneficial.
- If You Have Large Pre-Tax Retirement Accounts
Substantial balances in traditional IRAs or 401(k)s can lead to large required minimum distributions (RMDs) later, potentially pushing you into a higher tax bracket. RMDs are required starting at age 73 (or later, depending on legislation), and these distributions increase your taxable income. However, RMDs are not required with Roth IRAs. Converting some of these funds to a Roth can reduce future RMDs, giving you greater control over your taxable income in retirement.
- If You Plan to Move to a Higher-Tax State
State income taxes can play a big role in your overall tax strategy. If you're currently in a low- or no-tax state but plan to move to one with higher taxes, it may make sense to do Roth conversions before relocating. For example, converting funds while living in Florida (which has no state income tax) could be far more tax-efficient than waiting until you move to a state like California or New York, where taxes are considerably higher.
- If You're Married but May Eventually File as Single
The "widow’s tax trap" is a lesser known but significant concern for married retirees. When one spouse passes away, the surviving spouse will file taxes as a single individual, often resulting in higher tax brackets and a reduced standard deduction due to having to withdraw from 2 retirement accounts. Performing Roth conversions while both spouses are still alive and filing jointly can help reduce the future tax burden for the surviving spouse.
- If Your Heirs Are Likely to Be in Higher Tax Brackets
If you plan to leave money to children or other beneficiaries who are high earners, Roth conversions might be a smart estate-planning move. Under current rules, heirs must withdraw the full balance of inherited IRAs within 10 years. If they inherit a traditional IRA, these withdrawals are taxed as ordinary income on top of their already earned income. Converting funds to a Roth IRA ensures your heirs can withdraw money tax-free, potentially saving them significant taxes.
- If You Believe Tax Rates Will Rise in the Future
With changing tax laws and growing federal deficits, many retirees are concerned about the potential for higher tax rates in the future. The Tax Cuts and Jobs Act (TCJA) lowered many tax brackets, but these provisions are set to expire next year. If you expect rates to rise, converting now allows you to lock in today's “lower” rates and protect your retirement savings from future tax hikes.
Final Thoughts
Roth conversions aren't the right move for everyone, but for many approaching retirement age, they offer valuable tax-saving opportunities. Understanding these five scenarios can help you decide if a Roth conversion aligns with your financial goals.
Connor Maruna | Blakely Walters
Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.
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