The financial world has a way of turning simple concepts into intimidating jargon. And I think you can add “Roth Conversion” to that list. Sound complex? It is not!
A Roth Conversion is simply moving money from a Traditional IRA, or any other pre-taxed type of account, and putting it into a Roth IRA. When you do this, it creates a taxable event. The converted dollars are subject to ordinary income tax, and you would be taxed according to the tax bracket that you fall into.
So why would anyone want to pay tax on IRA money if they don’t have to? ….
Because choosing to pay the taxes now instead of later can create very impactful long-term benefits on your investment dollars, especially if you are in a lower tax bracket now than you will be in the future.
There might be several reasons you decide to convert to a Roth. Maybe you want to create a tax-free legacy for your family after you’re gone. Or maybe position yourself to be able to take a lump sum distribution later in life without any taxation. All very good reasons. But the main determinate on whether you decide to convert pre-taxed dollars to a Roth should be your tax rate situation.
Remember, when we convert, we have to pay taxes and we lose some of that money that we could continue to compound. This is an important aspect that we cannot disregard. After all, it takes time to make up that lost investment capital. However, if you’re going to have to pay taxes at a higher rate when you actually access the funds, then paying the taxes upfront at a lower rate upon the contribution to the account will make the most mathematical sense.
Good tax planning can often take negative situations and create a positive action out of them...
Roth Conversions are included!
For example, if you lose your job or you get laid off, and in that particular year your income drops off substantially, you just might find yourself in the lowest tax bracket that year that you’ll ever be in. Boom! This could be a perfect time to convert some of your 401k or Traditional IRA dollars to a Roth.
Another great time to convert … The stock market being down. How come? Let’s put an example on it… Say you own a stock that use to be worth $100 and is now worth $80. If you were to convert that stock to a Roth while it’s down, you would pay taxes on the $80, not the $100. When that stock appreciates back to $100, you now have that same investment in a Roth but you paid a lot less in taxes to get it in there.
As with most financial decisions, the answer to the question – “Is a Roth Conversion right for me?” is … It depends. Everyone has unique circumstances and many of us have different financial goals. It’s important to evaluate your situation in its entirely before making your decision. But hopefully this short article helps you with your answer.