When Is the Best Time To Do a Roth Conversion?

Roth conversions aren’t nearly as scary as they may sound. They can also be one of the more valuable financial planning tools available to everyday investors, especially if used properly.

Here, we’ll go through what a Roth conversion is, why the end of the year is an optimal time to think about Roth conversions, and, finally, how to successfully complete one.

What is a Roth conversion?

In the most simple terms, a Roth conversion is the movement of funds from a pre-tax retirement account (like a 401(k) or Traditional IRA) to, most commonly, a Roth IRA. During the conversion, you explicitly move funds from pre-tax status to post-tax status; while this will set off some alarms in that tax will be charged on any amount converted, this is done (hopefully) voluntarily and purposefully.

The idea is to take money from accounts that have an embedded tax liability and move that money to (usually) a Roth IRA, which is permanently tax exempt. This allows any money converted to grow freely without any worry over future taxation. Roth IRAs are also great estate and education planning tools.

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When is the best time to do a Roth conversion?

The answer here is twofold. First, the best time to do a Roth conversion is in a lower-income year. If you earn less money than you usually do in any given year, you’ll fall into a lower tax bracket. While you’ll earn less money overall, this can be an opportunity to convert pre-tax assets to Roth status.

Imagine you’re a single earner making $175,000 annually. This puts you in the 32% federal tax bracket — not the highest bracket, but additional income is only two-thirds yours at this level. Annual income in this bracket would likely indicate a less-than-ideal year to go for a Roth conversion.

Now imagine the following year, you’re laid off after the first quarter, and you manage to collect a total of $50,000 in salary for the year. This puts you squarely in the 22% income bracket for the year, with about $35,000 worth of space before you hit the 24% bracket.

In the lower income year, you have an opportunity to complete a Roth conversion (removing pre-tax retirement money and making it post-tax retirement money) at a lower marginal tax rate. Clearly, paying tax at a rate of 22% on your Roth conversion would be better than paying 32% as you would in a typical tax year.

Within the low(er) income year of your choice, it’s best to wait to the end of the year to finally complete a Roth conversion. You’ll have a better idea of your total income for the year and, ultimately, your marginal tax bracket. If you complete Roth conversions too early in the year, you may accumulate income later on and be pushed into a higher tax bracket than you intended.

Remember, Roth conversions are completely voluntary. You can choose to leave all of your money in pre-tax retirement accounts for as long as the IRS will allow. At 72, you’ll be forced to take at least a portion of your money out in the form of Required Minimum Distributions (RMDs). But you can get away with paying as little as possible in federal tax if you time your Roth conversions correctly.

How to complete a Roth conversion

Shockingly, this is the easiest part. You can complete a Roth conversion by contacting your 401(k) or IRA provider and requesting that a portion of your retirement balance be converted to a Roth account of your choice. If you’re a purely DIY investor, there is an option to “convert to Roth” on most account dashboards (though this will only apply to pre-tax IRAs and some employer plans).

You’ll need to be very careful about keeping track of the “flow of funds.” If you move money from an employer-based 401(k) directly to a Roth IRA at an outside provider, you’ll need to keep track of the exact amount so it can be added to your taxable income at the end of the year. In additional, come tax time you’ll receive documentation regarding the transfer of assets.

A plan always helps

Sound financial planning acknowledges that things can and will go off course, but you can build in a margin of safety to guard against unexpected outcomes. Converting all of your pre-tax retirement money to Roth in a single year might be wasteful, but not converting any might be too defensive. Be proactive with your tax and retirement planning to take advantage of every tool you have.

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