Thinking About a Roth Conversion? Answer These 4 Questions First

It might be tempting to do a Roth conversion when the market is tumbling. Since the value of your investments may have declined, you'll save on taxes when you make the conversion. 

But it's important to look at all the numbers involved in a Roth conversion to determine the best time to take action. We've nailed down four questions you should consider to make your decision easier. 

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1. How much money do you have in your traditional retirement account?

Contributions to many employer-sponsored plans like a 401(k) or 403(b) plan are made on a pre-tax basis. That means you didn't pay taxes on that money before it went into your retirement account. When you do a Roth conversion, that money will be counted as income. You'll have to plan ahead for taxes. 

If you want to do a large Roth conversion, it could push your income into a higher tax bracket. Let's say you have $150,000 in an old 401(k) and $50,000 in a traditional IRA. If you decide to move all of your money from an old 401(k), that could lead to a huge tax bill if you're already in a high tax bracket.

It's good to think about which retirement assets you may want to move into a Roth IRA and find out how much money you have in the account, so you can calculate your potential tax hit. 

2. How much income do you expect to earn this year?

Calculate all of your income sources for the year, and the total taxable income you expect to receive. Remember, the money you move into a Roth IRA is a taxable distribution. It will be treated as ordinary income, and will be added to all your other income sources for the year. This means the extra income from a Roth conversion could bump your income into a higher bracket.  

But let's talk about how tax brackets really work: Only a piece of your income will fall into that higher tax bracket.

If you're married filing jointly, you pay 10% on the first $20,550 of taxable income. Then, you pay 12% on income between $20,551 and $83,550, 22% on income between $83,551 and $178,150, and so on. 

Here are the 2022 ordinary income tax brackets that you should be aware of. Calculate your total income to determine which tax brackets you may fall in. This will help you determine if a Roth conversion would push your income into another bracket. 

Table source: Author. Data source: IRS.

3. Do you expect to pay more taxes later?

You can do a Roth conversion now, or push it off until a later date. If you think you'll have to pay more taxes on the money later, it makes sense to pursue a Roth conversion now. But it can be hard to predict what future tax rates will be. 

This is where tax planning comes in. You can work with your CPA or tax advisor to help you develop tax strategies that align with your goals. Although you don't have a crystal ball showing you future tax rates, you can put a strategy in place to minimize your tax liability, no matter what direction the rates go in. 

4. When do you plan to retire? 

If you're not close to retirement age, there's something to consider when doing a Roth conversion: the five-year rule. If you convert a traditional retirement account into a Roth IRA, you'll have to wait five years before taking penalty-free withdrawals. The IRS won't let you get away with pursuing Roth conversions just so you can gain access to traditional retirement accounts without a penalty.  

But the good thing about the five-year rule is that the clock starts ticking on Jan. 1 of the year of the conversion, even if you do a Roth conversion later in the year. You need to be aware of the five-year rule for each Roth conversion you plan to do, because the clock starts over for every new conversion. 

There's a lot to consider when thinking about a Roth conversion, so review these questions to make sure you're putting your current and future self in the best financial position possible.