Financial expert Dallin Cutler from EP Wealth Advisors discusses three optimal times to do a Roth conversion and key factors he considers with clients.

WHEN TO DO A ROTH CONVERSION

Converting your 401(k) to a Roth IRA allows you to enjoy tax-free withdrawals in retirement. Required Minimum Distributions (RMDs) come into play with traditional IRAs and 401(k) plans once turning age 73 if you are born before 1960, and age 75 if you are born in 1960 or after. However, Roth IRAs are not subject to RMDs, and any withdrawals you make are tax-free.

WHEN IT MAKES SENSE TO DO A ROTH CONVERSION

There are three main times in which doing a Roth conversion is a good idea:

1. At retirement
2. When you want to take advantage of lower tax brackets
3. When the market drops

For many clients, the sweet spot to make Roth conversions is after retirement and before filing for Social Security. It is a period when income is lower, which can provide an opportunity to make Roth conversions.

Life might hand you lemons if you get laid off. But you can make some lemonade out of this experience by opting to do a Roth conversion. This is when you may be taking advantage of tax brackets because your job loss puts you in a lower bracket temporarily.

When the markets drop significantly, it takes a toll on your account balances and can affect your emotional state. A silver lining of a down market is that the impact of making Roth conversions can be amplified. If a Roth conversion is made during a downturn, the amount of taxes due would be less compared to a conversion being done prior to the market falling. The converted amount with the Roth IRA can then participate in the recovery and growth of the markets and be withdrawn tax-free.

Although you can do a Roth conversion at any age, keep in mind that once you are subject to required minimum distributions, you must take RMDs before converting.

ROTH CONVERSION ANALYSIS

The right time to do a Roth conversion depends on a number of factors, which can include your current tax rate versus your projected future rate, the size of the tax bill you'll pay for the conversion, and your overall retirement strategy. If your tax bracket is higher now than when you start making withdrawals, you could end up paying more in taxes due to the conversion than you would save making later tax-free withdrawals.

When a client is considering a Roth conversion, a financial planner at EP Wealth Advisors will first perform a robust analysis of the previous year's tax return. We'll look at all components, including federal, state, and Medicare taxes to see how they will impact the client. For instance, your income can affect your Medicare premium. By converting just the right amount of pre-tax retirement funds, there could be a possibility to avoid paying more for Medicare.

Your current income sources play a crucial role in this analysis. Income from Social Security, pensions, real estate investments, and other retirement accounts can affect your tax bracket and the optimal timing for a conversion. Converting too much in a single year could push you into a higher tax bracket, potentially reducing the benefits of the conversion.

The size of your traditional IRA or 401(k) also influences the conversion strategy. Larger accounts might benefit from a multi-year conversion strategy, where you convert portions of the account over several years to manage the tax impact. This approach could help you stay within desired tax brackets while steadily building your tax-free retirement savings.

Market conditions at the time of conversion should also factor into your decision. Converting when account values are temporarily lower due to market conditions could reduce the tax cost of the conversion. However, this timing should align with your broader investment strategy and not be the sole determining factor.

Estate planning objectives might also influence your conversion decision. Roth IRAs can be particularly valuable for legacy planning since they don't require RMDs and can provide tax-free income to your beneficiaries. This benefit should be weighed against your current tax situation and immediate financial needs.

Remember that a Roth conversion analysis isn't a one-time event. Changes in tax laws, your financial situation, and market conditions might warrant regular review of your conversion strategy. Working with a financial advisor can help ensure your conversion strategy remains aligned with your overall financial goals.

When Not to Do a Roth Conversion

There are circumstances in which you should think twice about doing a Roth conversion. For example, if you don't have the cash available to pay the tax bill on the conversion, you could end up paying the tax out of the converted balance. That means less money for tax-free growth and could significantly reduce the long-term benefits of the conversion.

If you need to tap your Roth IRA money within the next five years after opening the account, you could pay a penalty. The five-year rule pertaining to Roth IRAs begins as of January 1 of the year in which you made the initial contribution. This rule applies separately to each conversion, so careful timing and planning are essential.

Additional situations where a Roth conversion might not be appropriate include:

• When you expect to be in a significantly lower tax bracket in retirement
• If the conversion would trigger higher Medicare premiums that offset the benefits
• When you plan to leave your IRA to a charity, which wouldn't owe taxes on the inheritance anyway
• If you're close to retirement and the conversion would deplete too much of your savings

COMMON CONVERSION MISTAKES TO AVOID

Even when a Roth conversion makes sense, the execution matters. Here are some common mistakes to watch out for:

Converting Too Much at Once

Converting your entire traditional IRA in one year could push you into a higher tax bracket, potentially negating the benefits of the conversion. Consider spreading the conversion across multiple years to manage the tax impact.

Poor Timing with Other Income

Some investors fail to consider other income sources when planning a conversion. For example, converting in a year with a large bonus or significant capital gains could result in paying unnecessarily high taxes on the conversion.

Ignoring State Tax Implications

While federal taxes often get the most attention, state taxes can significantly impact the conversion math. Some states treat Roth conversions differently than others, and failing to account for state tax impact could lead to unexpected costs.

Missing Key Deadlines

Unlike regular IRA contributions, Roth conversions cannot be undone or recharacterized after the fact. This makes timing and accuracy crucial, as mistakes cannot be reversed.

Not Considering Impact on Other Benefits

A Roth conversion could affect various income-based benefits and costs, including:

• Social Security taxation
• Medicare premiums
• College financial aid
• Child tax credits
• Other income-based deductions and credits

Failed Backdoor Roth Attempts

Some investors attempt a backdoor Roth conversion without understanding the pro-rata rule, which could result in unexpected tax consequences. This strategy requires careful consideration of all IRA assets, not just the amount being converted.

There are circumstances in which you should think twice about doing a Roth conversion. For example, if you don’t have the cash available to pay the tax bill on the conversion, you could end up paying the tax out of the converted balance. That means less money for tax-free growth.

If you need to tap your Roth IRA money within the next five years after opening the account, you could pay a penalty. The five-year rule pertaining to Roth IRAs begins as of January 1 of the year in which you made the initial contribution.

To discuss your retirement planning options and investment management strategies, contact a financial professional at EP Wealth Advisors today.

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