Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)
A Roth IRA conversion may be right for you if you have a year where your taxable income is lower than normal, or your income is too high to contribute to a Roth IRA outright ($144,000 and up for individuals in 2022; $214,000 and up for married couples filing jointly). With a Roth conversion strategy, you convert all or part of your traditional IRA to a Roth IRA and pay regular income taxes on the converted amount.
It may seem counterintuitive to pay taxes now that you could put off until later, but doing so will allow you to take advantage of a Roth IRA's main benefit: tax-free withdrawals of contributions and earnings in retirement (so long as you’re age 59 1/2 or older and have held the account for at least five years).1
"It's an attractive option for individuals who believe their tax rate may be higher in retirement, or for those who just want the flexibility that tax-free income provides," says Rob Williams, managing director of financial planning, retirement income, and wealth management for the Schwab Center for Financial Research. "And, unlike tax-deferred retirement accounts, Roth IRAs aren't subject to required minimum distributions beginning at age 72."
If you think a Roth IRA conversion might be right for you, Rob points to three tax-efficient strategies:
- Max out your bracket: Let's say you're single and make $150,000 a year, which puts you in the 24% tax bracket. The next bracket doesn't kick in until your income exceeds $170,051, so you could convert $20,051 ($170,051 minus $150,000) and still stay within your current bracket.
- Spread it out: Breaking up the conversion across multiple years can make the tax hit easier to manage—and could, when combined with the strategy above, reduce the overall tax you pay on the conversion.
- Get ahead of tax changes: If upcoming changes to tax law will adversely affect future taxes, converting some or all of your traditional IRA in the year preceding the change could help you avoid paying more tax on the conversion than necessary.
In any case, you may want to wait until the end of the year to perform the conversion. "That way, you can account for any year-end changes to your total taxable income. Or work with a tax professional to project your total taxable income for the year," Rob says. "Doing this can help create an annual plan to max out a selected tax bracket with conversions, and smooth out conversions—and taxes—over time."
1 For savers younger than 59 1/2, you can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA, depending on how long you’ve held it and how you’re using the money. See the complete rules here.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Roth IRA conversions require a five-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own five-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
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