Why you should consider a Roth conversion before year-end

As the end of the year approaches, those contemplating a Roth IRA conversion must make their move before December 31 to maximize its benefits for the following year. Here are the implications of Roth IRA conversions, both in the present and during retirement, to help you determine if this financial strategy aligns with your goals.

To understand how Roth IRA conversions work, one must grasp the shift in the government’s treatment of retirement savings. Converting funds from a tax-deferred traditional IRA or 401(k) to a Roth IRA alters the timing of tax payments. While traditional IRAs and 401(k)s provide an upfront tax break, withdrawals made in retirement are subject to taxes. Conversely, Roth IRAs require upfront tax payments on contributions but offer tax-free access to contributions and earnings in retirement.

Attractive due to their potential for tax-free withdrawals, Roth IRA conversions come with a catch: taxes must be paid on the amount converted in the current year. Individuals may increase their tax liabilities by doing so, potentially pushing them into higher tax brackets. To avoid this, most individuals wait until the end of the year when they have a clearer picture of their annual income and anticipated tax bracket.

Ideally, you should aim to stay within your current tax bracket, selectively converting only enough to reach its upper limit. For those with larger sums to convert, it is advisable to break the conversion into smaller increments and spread them out over several years to manage their tax obligations.

One crucial aspect of Roth IRA conversions is understanding the rules for accessing the converted funds. Roth IRAs follow a five-year rule, stipulating that earnings cannot be withdrawn penalty-free until five years after opening the account. This rule applies to direct contributions and conversions, with the clock starting on January 1 of the year when the conversion occurred. Even if a conversion is executed in December, the five-year countdown commences on January 1 of the subsequent year, thereby allowing penalty-free withdrawals from January 1, 2028. As a result, the money is effectively locked up for four years, making year-end conversions an appealing option.

Completing a Roth IRA conversion requires several steps. Firstly, open a Roth IRA account if you don’t already have one. Keeping the account with your traditional IRA provider is convenient but not essential. Contact both your current and new retirement plan administrators to notify them of your intentions and familiarize yourself with the necessary paperwork and any associated fees. Proactively initiating this process is recommended to ensure completion well before the year-end deadline.

Remember, the approaching year-end deadline warrants consideration for those contemplating Roth IRA conversions. Understanding the tax implications and the five-year rule for accessing converted funds is crucial. Individuals can optimize their retirement savings strategy by making informed decisions and carefully planning conversions. If you are unsure how to proceed, consider consulting a financial adviser.