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The stock market is sitting on a knife-edge, and interest rates are still top of mind, which has investors wondering what the Federal Reserve will do next.
Add in tax season being fresh in everyone’s minds, and it’s no surprise that many people are thinking about their retirement accounts and asking themselves: What should I be doing with my money?
While most people focus on getting their taxes filed or making that last-minute IRA contribution, this is also the perfect time to step back and look at the bigger picture. Are you contributing strategically, or are you just checking the box because you know you “should”?
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For many investors, another timely question comes up: Should you consider a Roth conversion?
The buzz around Roth conversions
Roth conversions have become one of the hottest financial buzzwords in recent years. But like most trends or fads, they’re often misunderstood.
In the simplest terms, a Roth conversion is when you move money from a tax-deferred account such as a traditional IRA or 401(k) into a Roth IRA. When you do this, you pay income tax on the converted amount immediately, but future withdrawals in retirement become completely tax-free.
That sounds great in theory, but it’s not a one-size-fits-all solution. Deciding whether a conversion makes sense depends on several factors:
- Your current income and tax bracket
- How long until you retire
- Your ability to cover the tax bill
- Your long-term goals
The good news is that whether you’re looking for tax-free income in retirement or want to leave a legacy, there are tools available to help make this decision a little clearer.
Financial advisers can run detailed reports showing the long-term benefits and trade-offs of doing a conversion, helping you see whether the numbers make sense for your specific situation.
All or nothing? Not quite
One of the biggest misconceptions about Roth conversions is that you must move all your retirement money at once. In most cases, that’s not advisable. Converting everything in a single year could trigger a huge tax bill and bump you into a higher income bracket.
Instead, many people choose to convert a portion of their traditional IRA or 401(k) over several years. This allows you to stay within a target tax bracket and better manage your tax situation.
Others use conversions as part of legacy planning, converting over five to seven years so that the money they pass on to children, grandchildren or charities is tax-free.
In other words, it’s not about doing it all — it’s about finding the right amount to convert at the right time.
When conversions make sense (and when they don’t)
Roth conversions can be a powerful tool, but they aren’t right for everyone. They typically make sense for people who:
- Expect their taxes to rise in the future
- Have enough savings to pay the tax bill
- Are in or nearing retirement and want to reduce future taxable income
On the other hand, conversions often don’t make sense for high earners who are already paying a top tax rate. For example, if you’re earning $500,000 a year, converting your IRA might add to your taxable income without providing any real benefit. In some cases, a conversion might cost more than it would save.
What about younger investors?
For younger savers or people who’ve recently changed jobs, the idea of converting old 401(k) accounts to a Roth IRA can be appealing. But the decision depends on whether you have the cash available to pay the taxes now.
A smarter move would be opening a Roth IRA directly and starting to fund it as early as possible. Investing just $20 a day would be enough to max out your annual contribution limit of $7,500.
If you stick with it and invest steadily (say, in a diversified index fund such as the S&P 500), that money could grow to more than $1 million over a 40-year career — and all of it would be tax-free when you retire.
That’s an incredible opportunity for anyone in their 20s or 30s, and one that’s far easier to achieve than people think.
More than just income taxes: How Medicare complicates conversions
Roth conversions are not just about income taxes. They can also affect your future healthcare costs.
When you hit retirement age and enroll in Medicare, your Part B and D premiums are based on your modified adjusted gross income from the two years prior to enrollment. Large withdrawals from a traditional IRA or 401(k) can increase your income and, with it, your Medicare premiums.
By converting some of your traditional retirement savings to a Roth earlier in life, you might be able to reduce your taxable income later and avoid those higher costs. It’s one of those planning details that often gets overlooked, until it’s too late.
Balancing buzzwords from real-life planning
Social media and financial blogs make it sound as if everyone should be doing Roth conversions, so it’s easy to get caught up in the excitement. Who wouldn’t want tax-free income later in life? But the reality is life isn’t that simple.
With another tax season complete, now is the time to look at your retirement strategy from a fresh perspective.
- Do you have a plan for where your money is going?
- Should you open a Roth or convert part of your IRA?
- How will today’s decisions affect your tax picture years from now?
Roth conversions can be an incredible tool for building tax-free wealth and protecting your future income, but they’re not for everyone or for every situation. The right approach should take into account your income needs, goals and time horizon.
The most important thing you can do is make an informed decision, not an emotional or impulsive one driven by social posts and headlines.