Roth IRA conversions help you avoid taxes on your retirement withdrawals, but they can make your taxes a little more complicated this year. If you're not careful, you could wind up with a bigger bill than you were anticipating. That doesn't mean a Roth IRA conversion is a bad idea, though. You just need to plan it carefully.
Here are two questions to ask yourself in order to decide whether a Roth IRA conversion makes sense for you and how much you should convert this year.
1. Does a Roth IRA conversion make sense for me?
A Roth IRA conversion is where you change some of your tax-deferred savings, which offer an upfront tax break in exchange for taxes on withdrawals, into Roth savings, which offer tax-free withdrawals with no upfront tax break. To do this, you pay taxes on the sum you're converting in the year you do it.
Tax-free withdrawals sound great, but Roth savings aren't the best choice for everyone. Those who believe they're in a higher tax bracket today than they'll be in once they retire might prefer to keep their money in a tax-deferred account. By putting taxes off until they're in a lower tax bracket, they might be able to hold on to more of their savings.
Only you can decide which type of savings makes the most sense for you right now. But it's important to consider both options before going through with a Roth IRA conversion. Once done, it can't be undone, so you have to be sure that it's the right decision for you.
2. How will a Roth IRA conversion affect my taxes?
When you do a Roth IRA conversion, the amount you're converting gets added to your tax bill for the year. So, for example, if you have $5,000 in a traditional IRA that you'd like to convert to a Roth IRA, your taxable income for this year will go up by $5,000. And since the money is locked away in a retirement account, you won't be able to use any of those funds to help offset your larger tax bill. If you believe you'll face a tax bill, you must have the savings to cover it already on hand in a bank account.
The worst-case scenario is that your Roth IRA conversion pushes you into the next tax bracket, forcing you to pay a larger percentage of your income to the government. That's something you want to avoid at all costs. Fortunately, it's not too difficult to do.
Most people wait until the end of the year to do Roth IRA conversions so they have a good idea of where they'll fall within their tax bracket. Then, they convert as much as they can without jumping up to the next tax bracket. The next year, they do the same thing, and so on until they've converted all that they want to convert.
Even following this approach, it's possible you could still find yourself facing a tax bill, depending on your income, tax withholding, deductions, and more. If you believe you could owe the government, make sure you have some cash on hand to help you cover this cost. Otherwise, look into payment plan options once you see how much you owe.
If you decide a Roth IRA conversion isn't the best move for you right now, you can always do it another year if you change your mind. It doesn't matter if you do the conversion right now or right before retiring. It's all the same to the government, as long as you pay taxes on the amount you're converting at some point.