Is an IRA Roth conversion right for you? | Vanguard (2024)

FAQs

Is an IRA Roth conversion right for you? | Vanguard? ›

Deciding whether to convert to a Roth IRA hinges on issues like your tax rate now versus later, the tax bill you'll have to pay to convert, and your future plans for your estate. And remember, the conversion will be permanent—you can't revert the money back to a traditional IRA.

Generally, a Roth IRA conversion makes sense if you:

Won't need the converted Roth funds for at least five years. Expect to be in the same or a higher tax bracket during retirement. Can pay the conversion taxes without using the retirement funds themselves.

Since a Roth conversion increases taxable income in the conversion year, drawbacks can include a higher tax bracket, more taxes on Social Security benefits, higher Medicare premiums, and lower college financial aid.

Deciding whether to convert assets to a Roth IRA depends largely on what you anticipate that your future income tax bracket will be. The conversion could be especially beneficial if you expect to be in a higher tax bracket in retirement—you'll pay the taxes now at your lower current rate.

Making in-plan Roth conversions while an investor's income is still taxed at the ordinary tax rate is a good strategy. This means they'll pay much less in taxes now, rather than pay higher conversion taxes later.

Money that you'll need soon isn't a good candidate for conversion because your assets may not have time to recoup the taxes you would have to pay. You're currently receiving Social Security or Medicare benefits.

Paying these taxes upfront can be a significant psychological hurdle, but it's a critical investment in your future financial security. An ideal candidate for Roth conversion is someone who understands the value of tax-free growth and is comfortable with the trade-off of paying taxes now to save more in the long term.

There's no age limit or income requirement to be able to convert a traditional IRA to a Roth. You must pay taxes on the amount converted, although part of the conversion will be tax-free if you have made nondeductible contributions to your traditional IRA.

You need the liquidity outside of your IRA to pay the taxes due. If you are converting $100,000 you need to have between $30,000 and $41,000 to pay the taxes. Assuming your Roth IRA can grow at a 6% rate of return, it will take you a minimum of 10 years to break even.

While there's no way to avoid conversion taxes completely, you can restructure them to make this much more manageable. By staggering out your conversion or timing it for years in which you have low tax liability or portfolio losses, you can reduce the impact of a Roth IRA conversion.

At what age does a Roth IRA not make sense? ›

You're never too old to fund a Roth IRA. Opening a later-in-life Roth IRA means you don't have to worry about the early withdrawal penalty on earnings if you're 59½. No matter when you open a Roth IRA, you have to wait five years to withdraw the earnings tax-free.

A Roth IRA works best when it has time to grow, and when you can take advantage of tax arbitrage between current (lower) rates and future (higher) ones. For example, say that you're 70 years old with $1.2 million sitting in your IRA. Legally it's not too late to convert that money into a post-tax account.

In some cases, a Roth IRA can provide you with so much reportable income that you're bumped into a higher tax bracket. With a bracket-bumping conversion strategy, you can avoid this scenario by converting only a portion of your funds to preserve your current tax bracket.

The Five-Year Rule

The best time to convert from a traditional to a Roth IRA is generally when the market is down and your traditional IRA has lost value, and/or your income is unusually low, and/or your itemized deductions for the year have increased.

If you expect yourself to be in a higher income tax bracket in retirement, a Roth IRA conversion may make sense. It's an opportunity to be tax-efficient with your retirement funds by paying the tax when your tax bracket is lower. In many instances, it is difficult to influence your tax bracket.

Despite the appeal, Roth conversion has a number of drawbacks and limitations and is not for everyone. One of the major considerations is whether you will be in a lower tax bracket after retirement. If you are, you may be better off paying taxes then on IRA withdrawals rather than paying taxes now to convert to a Roth.

Cons: All or part of a backdoor Roth IRA conversion could be a taxable event. You may have to pay federal, state, and local taxes on converted earnings and deductible contributions. Conversions could kick you into a higher tax bracket for the year.