Should You Consider a Roth IRA Conversion This Year?


Autumn is here. That means it’s time for pumpkin spice lattes, Halloween, and year-end partial Roth IRA conversions. It’s everything you need to take that bit of chill from the air.

Roth IRAs offer tax-free growth and withdrawals for the rest of your life. Of course, the problem is getting the money in there in the first place. There’s only a limited amount you can contribute each year and that goes away if you earn too much.

However, you can always make a Roth IRA conversion instead. This is where you take a portion of your traditional IRA, pay ordinary income taxes on that amount, and move those assets into your Roth IRA.

Having Roth IRA assets in retirement could potentially lower your lifetime tax bill. However, it may not always make sense to do a Roth IRA conversion in any given year. With the markets being down in 2022, the temptation can be high to make a conversion this year. Here are four things to consider before making a Roth IRA conversion in 2022.

Of course, every person’s situation is different, so please consult with your financial planner and CPA before making any final decisions.

1. Do You Expect to Pay Lower Taxes in Retirement?

The original idea behind tax-deferred retirement accounts, such as your 401(k) or IRA, was that a worker would pay less in taxes in retirement than they did during their working years. The money they took from their tax-deferred accounts, therefore, would be taxed at a lower rate than what they would have paid while they were working.

Retirement accounts were designed to give workers these tax savings as an incentive to save for retirement.

If you expect to be in a much lower tax bracket during retirement, it may not make much sense to pay taxes on a Roth IRA conversion during your working years while your taxes are at higher rates. It might make more sense to wait until retirement to make these conversions at a lower effective tax rate.

However, if you expect to receive a pension or other taxable income after you stop working, you may find that your effective tax rate isn’t much lower than what you saw during your working years. If that’s the case, a Roth IRA conversion may make sense for you.

2. Can You Pay the Taxes?

If you make a Roth IRA conversion, you’re going to owe Uncle Sam ordinary income taxes on the amount you convert. That means you’ll need to write a bigger check on April 15th of the following year.

If you don’t have the funds to pay the tax bill on a Roth IRA conversion, you may want to think twice.

Don’t mess with the IRS. Years ago, I had one client who continuously refused to pay his taxes. As you can imagine, that didn’t end well.

3. Will You Need the Money Within 5 Years?

Remember, you typically must wait 5 years before you can withdraw any contributions from a Roth IRA. This applies to each and every Roth IRA conversion you make along the way. And just to make things more complicated, the clock starts at the end of the tax year the conversion is made.

Why does the IRS impose this rule? Simple – they want to discourage people from making Roth IRA conversions to avoid the penalties they would otherwise pay for withdrawing funds before age 59-1/2. You may remember that traditional IRA distributions before that age are subject to both taxes and a 10% penalty. This closes the loophole if someone wanted to access those funds early without paying the penalty.

If you break this rule, you’ll owe a 10% penalty on any distributions you make from your Roth IRA.

To learn more about all the five-year rules that apply to Roth IRAs, check out this blog post.

4. Are Your Roth IRA Beneficiaries in a Lower Tax Bracket?

If you don’t think you’ll need your Roth IRA assets for your retirement goals, it’s good practice to think about the perspective of your account beneficiaries. If you expect your heirs to be in a high tax bracket, then passing along Roth IRA assets would make sense. How generous are you to think of such a thing?!

However, if you expect your beneficiaries to be in a lower tax bracket than you, consider skipping the Roth IRA conversions. It may make more sense for your heirs to pay ordinary income taxes on their inherited traditional IRA withdrawals than for you to pay the conversion taxes at a higher rate.

Hopefully, they’ll be grateful either way. And if not, it’s time to cut them out of the will!

Should You Make a Roth IRA Conversion This Year?

Unfortunately, there’s no clear-cut way to tell if a Roth IRA conversion is right for you this year. However, with the drop in asset valuations we’ve seen in 2022, a conversion should be on your list to discuss with your financial advisor or CPA before the end of the year.

But be sure to get your professionals involved early. If you wait until December 30th, you may not be able to get it done in time. The big account custodians and brokerage houses have started closing the window for year-end conversions earlier and earlier over the last few years.

If you need help smoothing out your tax bill in retirement, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.

As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.

Prana Wealth Management LLC (“Prana Wealth”) is a registered investment advisor offering advisory services in the State of Georgia and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. The presence of this website on the Internet shall not be directly or indirectly interpreted as a solicitation of investment advisory services to persons of another jurisdiction unless otherwise permitted by statute. Follow-up or individualized responses to consumers in a particular state by Prana Wealth in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdiction requirements or pursuant an applicable state exemption.
All written content on this site is for information purposes only. Opinions expressed herein are solely those of Prana Wealth, unless otherwise specifically cited. The material presented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation.
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