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Clients often ask, “Should I convert part or all my pre-taxIRA or 401(k) into a Roth IRA?”
Here are eight factors to consider along with some obstacles that could get in the way.
1. You know the saying “without a plan, any road will get you there.”
Map out your Roth conversion strategy by first understanding and estimating the current year’s tax bracket. Examine where you were the prior year and guess where you will end this year. Chances are, you are in the same marginal bracket indexed for inflation. However, be mindful of any changes in income or deductions, such as the sale of a property or other capital asset.
2. Understand where your taxable income might be the following year.
Timing is everything. Try to forecast your future income and deductions. Will your marginal tax bracket increase next year? If yes, perhaps now is an ideal time to convert. If you expect a decrease in income next year, that is likely the better time to convert. Consider the following scenarios:
- A transition period of work. If you plan to take time off during the year, this could put you in a lower tax bracket than normal.
- Lower profits from your business could bump you into a lower tax bracket.
- Are tax laws changing in the future? Given expected changes to various brackets in 2026, the next three years may be an opportune time to convert.
3. Your account holds depressed stock you believe in long-term.
Ideally you want to convert at a discount. If the price of ABC stock is down 30%, not only do you pay fewer taxes on the conversion, but the future growth will accumulate tax-free and be available for tax-free withdrawals.
4. The five-year rule.
Per IRS guidelines, any earnings from a Roth IRA conversion must remain in the account for a minimum of five years or until age 59.5, whichever is later. Should you disregard this rule, earnings will be taxed as ordinary income (along with a 10% early withdrawal penalty tax if you are under age 59.5).
5. Outside cash available to pay the taxes.
You cannot withhold taxes from the conversion itself. Therefore, you must be prepared for a higher tax bill come April 15 of the following year. If you proceed with a conversion, ensure you have separate funds earmarked for increased tax liabilities. While you can fund in the pre-tax IRA or 401(k) to pay the taxes due on the conversion, that will cause those funds to be taxable and subject to the 10% penalty tax if you’re under age 59.5.
6. Time.
The more you have on your side (younger investors) the better. A longer timeline provides time to recover from accelerated tax liability as a result ofthe conversion It also provides longer tax-deferred growth for future tax-free income. Furthermore, the earlier in the year you decide to convert, the more time you have to pay the resulting tax liability.
7. In-service Roth conversions or after-tax monies within your current employer’s 401(k) plan.
Earnings on your after-tax 401(k) assets are re-invested in the pre-tax portion of your plan. Inquire about the feasibility of moving the after-tax portion of your plan into a Roth 401(k) orRoth IRA. This will allow the earnings to grow tax-free and increase the amount of available tax-free income throughout retirement. You can also consider in-service Roth conversions within your plan but they may not be available until you are at least 59.5. Review your employer’s plan options to see if this feature is available.
8. Tax bracket in retirement is normally an important factor in analyzing whether to do a Roth conversion.
It pays to diversify tax-wise when it comes to saving for retirement. We never know which tax bracket we may find ourselves in down the road. A lot of clients I’ve worked with accumulated a considerable amount of wealth in their pre-tax qualified plans and believed they would be in a lower tax bracket at retirement, only to find themselves in the same bracket as their working years with various unintended consequences) And who knows where tax rates are headed!
Conclusion:
You don’t have to rip off the band-aid and convert all of your pre-tax IRAs and 401(k)s in one year. Consider rolling Roth conversions.The idea here is to identify years where your income might be temporarily lower and convert in pieces. Say you retire at 65. Required minimum distributions begin at age 73 or later. This gives you eight years to spread out the conversions and remain within your current tax bracket. But, beware of unintended consequences. By increasing your income through a Roth conversion, you may subject yourself to a 3.8% Medicare surtax or increased Medicare premiums.
Finally, the converted Roth has useful benefits from a legacy perspective. Even though the beneficiary must take mandatory withdrawals (assuming a non-spouse), those distributions are tax-free, so they may provide more flexibility for the recipient’s planning purposes.
Speak to a trusted tax advisor and financial professional to help identify if converting your pre-tax IRA or 401(k) into a Roth IRA is right for you. Use these thought-starter questions as a guide to prepare in advance for those important conversations.
This information is for educational purposes only.This is not intended to provide and cannot be relied upon as, legal or tax advice. We suggest that you consult with your own legal and tax professional aspart of this process. Any legal agreements entered into with other financial professionals are soley between you and those individuals. The views expressed are those of Mathew DelPriore only. Any examples are generic, hypothetical and for illustrative purposes only.
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