Falling household income is generally not a desirable situation. However, there may be a tax-saving silver lining to earning less money coming in the form of a Roth IRA conversion.
A Roth IRA conversion occurs by taking funds held in a pre-tax IRA and converting them into post-tax Roth IRA funds. The goal of this strategy is to pay taxes now at lower tax rates than what you will likely have to pay later during your retirement years.
From a tax perspective, funds that are being converted to a Roth are treated as earned income in the calendar year the conversion takes place. So, while a Roth conversion can be done at any time, conversions are particularly attractive in years when household income is temporarily or permanently depressed.
For example, if a married couple with $200,000 of income saw their income temporarily drop one year to $75,000 due to some unique circumstances, their tax rate would go from 24% to 12%. They could potentially take advantage of their decline in income by converting roughly $25,000 of IRA funds (assuming they had standard deductions) to a Roth IRA and pay only 12% tax on those funds, which is an attractive tax rate for most tax payers.
Other advantages Roth IRAs have over a traditional IRAs is that Roth funds grow tax free (vs. tax deferred) and Roth’s are not subject to RMDs (Required Minimum Distributions) at age 70 ½.
The Roth conversion might not always make sense, but here are five great times to explore a Roth conversion:
- Going to School – Heading back to school full or part-time? If so, your income will likely take a substantial hit. A Roth conversion may be especially attractive since you’ll probably be earning more money (and pay tax at a higher rate) when you get back into the workforce.
- Job Loss – If you lose your job, finding another one might take months or longer, especially for high income professionals. The temporary hit to your earnings may provide an opportune time to convert to a Roth. Of course, you would need to make sure you have adequate cash reserves to tide you over while you are looking for your next position.
- Starting a Business – Those starting a new business will likely sacrifice their income for a few years as they get their venture off the ground. Again, as long as you have adequate cash reserves in place, it may be a great time to do a Roth conversion.
- Having a Bad Year – Those with “eat what you kill” style highly variable compensation structures may hit it out of the park in great years, but suffer during lean years. Those down years may not be all that bad if you save on your future tax bill by doing a Roth conversion.
- Early Retirement – Retiring in your 60’s or earlier? If so, you may have a great opportunity to shift funds from pre-tax retirement accounts into a Roth IRA. Since Social Security benefits and mandatory distributions from pre-tax IRAs will drive up your income and potentially your tax bracket at age 70 (assuming you delay IRA distributions and Social Security benefits until then), the time between your last pay check and age 70 may be a “sweet spot” for Roth conversions.
Generally speaking, Roth conversions should only be contemplated when you have adequate funds and cash reserves held outside your IRA accounts to pay any tax due and at that time. SMS can help evaluate your particular circumstances and determine if a Roth conversion or other tax strategy may be a suitable for you.