Contributed by: Kelsey Arvai, CFP®, MBA
We’ve just entered Autumn, and the new year is around the corner, making this the ideal time to consider a Roth Individual retirement account (IRA) conversion to save on future taxes. A Roth Conversion is a financial maneuver that allows you to convert funds from a Traditional Individual Retirement Account (IRA) or pre-tax funds into a Roth IRA or future tax-free funds. There are several important considerations and potential tax implications.
Stated another way, a Roth Conversion involves taking some or all the funds from your Traditional IRA and moving them into a Roth IRA.
Tax Impact: Before doing a Roth Conversion, it’s crucial to understand the tax implications. The amount you convert will be added to your taxable income for the year the conversion occurs. In other words, you’ll need to pay income taxes on the converted amount in the year of the conversion. It’s important to consider what tax bracket you are in. You could pay a large upfront federal and state tax bill depending on the conversion size.
Additionally, when your adjusted gross income is boosted, you might pay higher Medicare Part B and Part D premiums or lose eligibility for other tax breaks, depending on your situation.
Future Tax Benefits: The primary benefit of a Roth Conversion is that once the money is in the Roth IRA, future qualified withdrawals (including earnings) are tax-free. Tax-free withdrawals are especially advantageous if you expect your tax rate in retirement to be higher. Typically, a partial or full Roth Conversion is more attractive in lower-earning years because there could be a smaller upfront tax liability. It may be beneficial for you to lock in lower rates now before they sunset in 2026 (the highest federal income tax bracket rate may move from 37% to 39.6% unless there are changes from Congress).
Timing: It’s important to consider your financial situation and whether you have the cash on hand to pay the taxes. If you choose to pay taxes from the converted fund, you may erode the long-term benefits of the conversion. A longer investing timeline is preferred because there’s more time for tax-free growth to offset the upfront cost of the conversion. Remember the five-year rule, which requires investors to wait five years before withdrawing converted balances without incurring a 10% penalty, with the timeline starting on January 1st of the year of the conversion. Without proper planning, you could deplete your savings or trigger an IRS penalty, so working with your Financial Advisor and Tax Advisor is essential. Contact us if you have questions or want to check if this strategy is a good fit!
Kelsey Arvai, CFP®, MBA is an Associate Financial Planner at Center for Financial Planning, Inc.® She facilitates back office functions for clients.
Opinions expressed in the attached article are those of Kelsey Arvai, MBA, CFP®, and are not necessarily those of Raymond James. Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC. Investment advisory services offered through Center for Financial Planning, Inc.® Center for Financial Planning, Inc.® is not a registered broker/dealer and is independent of Raymond James Financial Services.