Retirement brings an end to working 9 to 5, but it doesn't always change things as much as people expect. You'll still need to budget carefully to ensure your savings last, and the government will still expect a cut of your money.
Most people never avoid taxes entirely in retirement, but having Roth savings can reduce how much you owe. You could save in a Roth IRA or Roth 401(k), but that's not the only way to increase your savings. You could also try a Roth IRA conversion as outlined below.
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What is a Roth IRA conversion?
A Roth IRA conversion is when you convert tax-deferred retirement funds, like those in a traditional IRA or 401(k), into Roth funds. Essentially, this changes your savings from pre-tax dollars to after-tax dollars. As a result, you won't owe the government anything when you withdraw your savings in retirement.
But in order to do this, you must pay taxes on the funds you're converting in the year of the conversion. So if, for example, you convert $5,000 in traditional IRA funds to a Roth IRA in 2023, you'll be adding that to your 2023 taxable total.
This will lead to a smaller tax refund or possibly a tax bill. Those who owe won't be able to tap their newly converted Roth IRA funds to pay the bill, so it's important to make sure you have enough cash on hand to cover the extra taxes.
Is a Roth IRA conversion worth it?
Only you can decide whether a Roth IRA conversion makes sense for you. It's probably not a good idea if you don't think you can handle the additional tax burden this year. But if you are comfortable with this and you expect that you'll be in the same or a higher tax bracket in retirement, it could be a wise move.
As long as you hold your converted Roth IRA funds for at least five years and until you're at least 59 1/2, you won't owe any taxes when you finally withdraw them. That could reduce your retirement tax bill significantly.
But now might not be the best time to do a Roth IRA conversion, even if you think it's a smart move. It's generally wise to wait until the end of the year to do this. That way, you'll have a better idea of where you'll fall in your tax bracket for the year.
Most people who want to do a Roth IRA conversion, especially if they're converting large sums, are careful to ensure that the conversion doesn't push them into the next tax bracket. This could significantly increase how much you owe the government this year. Instead, it's best to convert just enough to take you to the top of your current tax bracket. If you have more you would still like to convert, you can save it for 2024 and beyond.
How do you do a Roth IRA conversion?
The first step in a conversion is to open a Roth IRA if you don't already have one. You can do this with just about any broker. Look for one that makes it easy to manage your account and charges few fees.
Then, reach out to your old retirement account provider and tell it how much you would like transferred and where to send it. You'll have to fill out some paperwork to do this, and your plan administrator might charge a one-time fee in order to facilitate the transfer.
Don't forget to notify the IRS that you did the conversion when you submit your next tax return. This will tell the IRS to tax you on these funds now rather than in retirement.
The whole process doesn't take too long, so you still have time to think about whether a Roth IRA conversion is right for you. And if you don't think it's a smart move now, you can always wait a year or two before trying it.
