Are you considering a Roth IRA conversion? If so, your timing can significantly reduce the tax bite. A conversion involves transferring retirement funds from a retirement account, such as a traditional individual retirement account (IRA), which is funded with pretax dollars, to a Roth IRA, which is funded with after-tax dollars. This means that you’ll owe tax on the money you convert. One way to lessen the tax burden is by making the switch when your IRA’s value has dropped due to a market downturn.
The key difference between traditional and Roth IRAs is the timing of the tax advantages. You deduct contributions now and pay taxes on withdrawals later with a traditional IRA. Conversely, you don’t receive any up-front tax breaks with a Roth IRA, but qualified distributions are tax free.
Additionally, Roth IRAs carry no required minimum distributions (RMDs), so if you don’t need the money, you can leave the account alone to grow tax free for your heirs. This feature makes a Roth IRA an ideal wealth-transfer vehicle.
Another Roth IRA perk is that you can withdraw your contributions at any time (for any reason) with no tax or penalty. However, when it comes to Roth IRA conversions, you have to wait five years (the “five-year rule”) to withdraw converted funds to avoid a 10% penalty. The clock starts ticking on Jan. 1 of the year of the conversion, and a separate five-year period applies to each conversion.
The best time to convert from a traditional to a Roth IRA is generally when the market is down (and your traditional IRA has lost value), and/or your income is unusually low, and/or your itemized deductions for the year have increased.
You'll owe taxes on any converted funds the year you make a conversion, and the tax burden could be substantial. Still, there are several scenarios in which a Roth IRA conversion could be worth the effort—and the tax hit. These include if you:
If you are required to take an RMD from your traditional IRA in the year you convert, you must do so before doing the conversion. An RMD cannot be included in a roll over.
Here’s another scenario: Your traditional IRA’s value has dropped. You’ll owe tax on any funds you convert, so a stock market downturn could make a conversion more appealing, as you’ll pay tax on less money.
For example, say your traditional IRA was worth $100,000, and it drops to $60,000 when the overall market declines. In this situation you would be converting just $60,000 instead of the original $100,000—potentially shaving thousands of dollars off your tax bill.
Moreover, suppose your traditional IRA has lost value, and your income is lower than usual, or you have more itemized deductions (or both). In that case it can signal a particularly opportune time for a Roth IRA conversion. You’ll pay tax on a smaller converted amount, and your reduced taxable income and/or increased deductions could move you into a lower tax bracket, saving you even more money.
Of course, if you’re considering a Roth IRA conversion, weigh the up-front taxes and the consequences of boosting your adjusted gross income (AGI) before making any decisions. Be sure you have the cash on hand to cover the tax bill—any IRA funds used to pay taxes will miss out on tax-free growth for retirement, undermining the very reason for doing the conversion.
Also, be aware that an increase in taxable income could bump you into a higher tax bracket. It could also lead to higher Medicare costs, higher Social Security taxes, and the loss of certain write-offs, such as the student loan interest deduction or the child tax credit. Crunch the numbers first to ensure that the potential consequences don’t outweigh the benefits of the conversion.
Under the Tax Cuts and Jobs Act (TCJA) of 2017, you can no longer recharacterize converted funds back into a traditional IRA, in effect undoing the conversion.
If you decide a Roth IRA conversion is right for you, there are several ways to accomplish the switch:
No matter which method you use, the Internal Revenue Service (IRS) will collect the federal tax you owe when you file your tax return for the year of the conversion. Your IRA custodian will report the conversion as a distribution on Form 1099-R and the Roth contribution on Form 5498.
You probably can’t avoid paying taxes on a Roth IRA conversion, but there are ways to lower the tax bill. One way is to spread out the conversion over multiple years, making the tax hit easier to manage.
Another option is to max out your tax bracket. For example, say you’re single and earn $142,000 a year, putting you in the 24% tax bracket. The next tax bracket kicks in when your income exceeds $170,050. You could convert up to $28,050 ($170,050 – $142,000) without bumping up a bracket.
A Roth conversion ladder is a multiyear strategy in which you shift money from a tax-deferred retirement account—such as a traditional IRA or 401(k)—into a Roth IRA. However, instead of doing it just once, as you would with a standard Roth IRA conversion, you do a series of conversions over several years. If done correctly, you can withdraw the converted funds with no tax or penalty before reaching age 59½ —the age at which you can usually tap into your funds without taxes or penalties.
In 2022 the most you can contribute to all your IRAs is $6,000 per year ($7,000 if you’re 50 or older). However, there is no limit on the amount you can convert from a tax-deferred account, such as a traditional IRA, into your Roth IRA in a single year. Of course, you will owe tax on the converted amount, so it’s essential to weigh the pros and cons before converting any funds.
Bad news is hardly ever good news. But Roth conversions are one situation in which it can be. Whether the stock market is bad or your income is down this year, there could be a silver lining.
And here’s one more reason to consider a Roth IRA conversion: low tax rates and looming tax rate hikes. The current federal income tax rates, ranging from 10% to 37%, are set to expire at the end of 2025 if lawmakers don’t extend them, which would reinstate the higher 2017 rates. This means a Roth IRA conversion could save you even more if you will be in a substantially higher income tax bracket during retirement.
Internal Revenue Service. "Traditional and Roth IRAs."
Internal Revenue Service. "Publication 590-B(2020), Distributions from Individual Retirement Arrangements (IRAs): Roth IRAs: Additional Tax on Early Distributions."
Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions: Which Types of Distributions Can I Roll Over?"
Internal Revenue Service. "Be Tax Ready—Understanding Tax Reform Changes Affecting Individuals and Families."
Internal Revenue Service. "IRA FAQs: How Do I Convert My Traditional IRA to a Roth IRA?"
Internal Revenue Service. "Rollovers of Retirement Plan and IRA Distributions."
Internal Revenue Service. "Instructions for Forms 1099-R and 5498 (2022)."
Internal Revenue Service. "Topic No. 413 Rollovers From Retirement Plans."
Internal Revenue Service. "Retirement Topics – IRA Contribution Limits."
Congressional Budget Office. "Increase Individual Income Tax Rates."
Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."
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