One of the most common questions clients ask about Roth IRAs is “Should I make a Roth conversion?” If the answer is yes, the next question is “When should I convert?” While Roth conversions can make sense at any age, depending on your clients’ particular circumstances, generally speaking, the younger a client is, the more it makes sense.
Converting at a young age gives them the longest amount of time to let their money grow tax-free. And the chances are their retirement account balance is lower earlier in life than it will be as they get close to retirement, so the cost of converting may be less. Here’s the rub though, general advice is only right, in general.
It does not apply to all situations and may not apply to theirs. Maybe a Roth conversion would be better for them when they retire instead of while they’re young.
How would you know? There are many factors to consider, but here are three reasons why encouraging a client to wait until retirement to make a Roth IRA conversion might make sense:
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(1) Their income may be lower.
This is probably the most obvious reason you might consider suggesting a client wait until they retire to make a Roth IRA conversion. When they convert an IRA, 401(k) or other eligible retirement account to a Roth IRA, they’re going to have to add the converted amount to their income for that year. If they’re already in a high tax bracket, any income they generate from a Roth conversion is going to be taxed at that rate — or higher. Adding more income might not be very tax-efficient.
Suppose, for instance, that a client and spouse both work and together, they have $200,000 of taxable income. That puts them towards the upper edge of the 28 percent tax bracket.
Now imagine they have $100,000 that they would like to convert to a Roth IRA. If they do so, their income will now be $300,000, pushing them out of the 28 percent bracket and well into the 33 percent tax bracket. They’ll also find that now some or all of their investment income, like interest and dividends, is subject to an additional 3.8 percent surtax, making their real top rate about 36.8 percent.
Ouch. In this case, waiting until they retire and they have less overall income may provide valuable tax savings.
(2) Their Expenses may be lower.
Roth IRA conversions usually don’t make sense if, to (help) pay for the conversion, clients have to dip into their tax-deferred retirement savings or the potentially tax-free Roth they’ve just created. The math simply doesn’t add up.