Since marginal tax rates are at a historical low, Roth conversions are all the hype right now. Many investors are doing their research to decide if they should jump on the conversion train. If you’re in this group or are just learning about the strategy, here are three reasons to consider a Roth conversion.
You Expect to be in a Higher Income Tax Bracket When You Retire
You’re Just starting your Career
You started your first job and contributed to your employer-sponsored 401k. After a few years, you decided to leave the company and rolled your 401k into an IRA. You’re starting to make decent money, but you’re still at a relatively low marginal rate – sub 24%.
Your current income is $85,000, and your marginal tax rate is 22 percent. Based on your career outlook and goals, your income will be much higher in the future — possibly two to three times what it is today.
Since you believe your income could be two to three times higher in the future, you’ll probably want to fund your 401k to reduce your taxable income. So between now and then, while your marginal tax rate is low, you may want to consider converting some or all of your Traditional IRA into a Roth.
You Believe Tax Rates Will Increase
You’ve done some research. Right now, you see historically low tax rates. Just 20 years ago, your $85,000 salary would have put you in the 31 percent marginal tax rate. You aren’t sure where future tax rates will go, but after seeing where they’ve been, you decide you’d like to pay taxes on some or all the money now because sometimes the devil you know is better than the devil you don’t know.
Your Income for the Year is Down
You’re in a Lower-Income Year
Sales professionals, business owners, and entrepreneurs are just a few who may experience fluctuating incomes. But they aren’t the only ones. If your income and marginal rate have dropped, you may want to consider a Roth conversion. This statement is especially true if this was a one-off year, and you expect your income to rebound.
You’re Taking a Sabbatical
A 2017 survey from the Society of Human Resource Management showed that nearly 17 percent of all employers offer sabbaticals. If you’re taking a sabbatical, your income will likely decrease, even if it’s a paid sabbatical. If you envision going back to work after the sabbatical and expect your marginal tax rate will be higher than your sabbatical year’s tax rate, you may want to consider a Roth conversion during your sabbatical tax year.
You’re Out of Work
Six months into 2020, the national unemployment rate is 11.1 percent. Millions of Americans were not expecting to be out of work at the beginning of the year. If you’re one of the 17.8 million unemployed Americans looking for a planning opportunity in an otherwise terrible situation, a Roth conversion may be your solution.
In The SECURE Act and How the SECURE Act could be Detrimental to Your Beneficiaries, I reviewed how the Act removed the stretch IRA provision for beneficiaries. If part of your financial plan includes leaving assets to your beneficiary(s), doing so through a Traditional IRA is not the most tax-efficient solution. The Roth IRA doesn’t allow you to sidestep the stretch IRA provision, but it does leave more after-tax dollars to your heirs.
The bottom line is that the rules behind Roth conversions can be complicated. Before you make this permanent and irrevocable decision, I recommend that you consult with your financial advisor, estate attorney, or tax professional.