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As year-end approaches, some investors may be weighing a Roth individual retirement account conversion to save on future taxes. But there are several things to consider first, experts say.
The strategy transfers your pretax or non-deductible IRA funds to a Roth IRA, which kick-starts future tax-free growth. But you have to plan for the upfront tax bill.
“Making a Roth conversion is a significant financial decision that carries both short-term and long-term implications,” said certified financial planner Ashton Lawrence, director at Mariner Wealth Advisors in Greenville, South Carolina.
Here are some key factors to consider before making a Roth conversion, according to financial experts.
1. Assess the short-term tax consequences
While a Roth conversion may offer long-term tax benefits, there’s potential for shorter-term consequences, Lawrence warned.
Depending on the size of the conversion, you could have a hefty upfront federal and state tax bill, which could deplete savings or trigger IRS penalties without proper planning, he said.
Plus, boosting your adjusted gross income can create other issues, like higher Medicare Part B and Part D premiums, or losing eligibility for other tax breaks.
2. Consider current and future tax brackets
“Roth conversions are a tax arbitrage,” so it’s critical to weigh your current and future tax brackets, said CFP Jeremy Finger, founder and CEO of Riverbend Wealth Management in Myrtle Beach, South Carolina.
Typically, a partial or full Roth conversion is more attractive in lower-earning years because there could be a smaller upfront tax liability. But some investors may want to lock in lower tax rates now before they sunset, experts say.
The Republicans’ signature 2017 tax overhaul trimmed most of the federal income tax brackets, with the highest rate falling to 37% from 39.6%. But those rates will revert in 2026 without changes from Congress.
3. Weigh the timing
“Timing is another crucial factor,” said Lawrence. Typically, a longer investing timeline is beneficial because there’s more time for tax-free growth to offset the upfront cost of the conversion.
You can run a projection with a financial or tax advisor to find out the break-even period before deciding whether to convert the funds.
You’ll also need to consider the “five-year rule,” which requires investors to wait five years before withdrawing converted balances without incurring a 10% penalty. The timeline begins on Jan. 1 on the year of the conversion.
Overall, there are several factors to assess, and “the timing of the conversion can significantly impact its financial outcomes,” Lawrence added.