Timing Is Everything for Roth Conversions: An Expert's Guide to the Right Strategy

Sunbeams on a wall calendar showing one month.

It’s such a common occurrence that financial advisers consider November and December — the last months in which most tax actions will count for the current tax year — to be “Roth Conversion Season.”

Clients looking to reduce their tax burden in retirement often rush to do so during the holidays because, at year-end, their overall tax picture for the year is clearer, letting them maximize their Roth conversions without causing unintended damage to their current tax bill.

It’s important not to be caught flat-footed, though: Start thinking about Roth conversions now rather than scrambling to decide what to do in the middle of the holiday season.

On its surface, a Roth conversion is simple: Move assets from a tax-deferred account, on which you would owe taxes when you withdraw money in retirement, to its Roth equivalent, where you pay taxes now but enjoy tax-free growth and withdrawals.

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Why convert to a Roth?

Regular tax-deferred retirement accounts such as traditional IRAs and 401(k)s have been popular for decades. Workers save into tax-deferred accounts on the assumption that when they retire they’ll be in a lower income tax bracket and therefore pay less in taxes on the money they’ve saved.

While that assumption sometimes proves true, there are many factors that could cost you more money by employing a tax-deferred savings strategy. Unlike Roths, traditional tax-deferred accounts have required minimum distributions (RMDs).

Once you reach RMD age — 73 for those born in 1951 through 1959 and 75 for those born later — the government requires you to withdraw a portion of your account each year.

The government’s objective is easy to understand: You deferred taxes on those accounts, and they want to collect those taxes eventually.

The government uses a calculation based on your life expectancy to determine how much money you must withdraw each year, whether you need it or not. The larger your account balance, the more you will have to withdraw and pay taxes on.

Tax policy could change decades down the road

Even if your compensation is modest throughout your career, if you save diligently into your 401(k), you could have a significant amount of money when you retire. It’s entirely conceivable that a 401(k) with $10,000 in it early in your career could hold more than $150,000 by the time you retire.

This raises an important question: Would you rather pay taxes on your retirement savings now, or wait and pay taxes on potentially 10 times that amount years from now?

There’s also tax policy to consider. The Tax Cuts and Jobs Act (TCJA) has put us in one of the lowest-income-tax environments in history.

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Even though the reelection of President Trump and a Republican-leaning Congress means these tax reductions are more likely to be extended, it would be surprising if tax rates remained this low decades into the future.

In deferring taxes on your retirement savings until retirement, you will have more money to be taxed due to growth and potentially a higher tax rate due to policy changes. It’s not hard to see how tax deferral could cost you more in the long run.

Your age makes a difference, too

There are considerations to discuss with your financial adviser before choosing a Roth conversion. One significant example is that if you are older than 59½, you can pay the taxes for a Roth conversion with money inside the account you are converting.

If you’re younger, paying the taxes with money inside the account would incur a 10% tax penalty for an early distribution. This means you will likely want to pay those taxes with other sources, such as your savings account.

Considering 20% of Americans who earn more than $150,000 per year live paycheck to paycheck, facing a four- or five-figure tax bill could be a tall order. Make sure you will be able to cover the taxes before you do a Roth conversion.

That’s just one example of how Roth conversions can be more complicated than they seem — the wrong timing and strategy can cost you money. It’s important to work with a financial adviser to determine whether a Roth is right for you.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.