With tax rates headed lower for many people, this might be a good year to consider a Roth conversion.
For the uninitiated, that’s when you withdraw funds from a traditional IRA, pay the tax now instead of later, and then move the funds into your Roth IRA. Once your savings are in a Roth, they’ll grow forever tax-free.
A Roth conversion makes sense if you want to take advantage of lower tax rates now and think your taxes might be higher in the future (you’re basically pre-paying taxes at today’s rates).
One big change in 2018 is that Roth conversions, like that described above, can no longer be “recharacterized” or undone. So doing a Roth conversion now is kind of the tax equivalent of “you break it, you buy it.” Once it’s done, you’ve got to pay up. No returns.
For example, if you convert $100,000 from your IRA, pay tax on that $100,000 withdrawal, then watch the value of your conversion tank in a market decline, you’ll be sad … and stuck.
That changes the Roth conversion strategy this year. Here are the new takeaways:
♦ Since Roth conversions can no longer be undone, in most cases you’ll want to wait until later in the year (think turkey time) to make sure a conversion makes sense. Another smart strategy is to do a series of smaller conversions throughout the year, to reduce the potential impact of market fluctuations. Also, don’t rush to convert if you might experience some kind of unexpected taxable windfall later in the year that could drive up your tax rate and make the conversion more costly than you bargained for.
♦ One of our favorite strategies is to use Roth conversions to “top up” your tax bracket (squeezing in as much income as possible without driving up your tax rate). To make that strategy work to perfection, we’ll need to get a good handle on your tax picture before year-end, so keep tabs on your income and expense items as the year progresses.
♦ Expecting lower income this year due to time off between jobs, or major business expenses? Your bad luck might have a silver lining, making it an ideal time for a Roth conversion. Just remember that a conversion makes the most sense when you have funds available outside of retirement accounts to pay the tax bill, so get ready to scrape together some cash at conversion time.
♦ On the other hand, if you’re planning to retire soon or quit your job, don’t rush to convert. It might be better to hold off until next year. Once your work income stops, you could drop into an even lower tax bracket, making your future Roth conversion savings pure gravy.