Many years ago (before I became a financial planner) I took a one year Sabbatical after my first full-time job out of college. It was one of the best decisions I’ve ever made in my life, although looking back there is one small aspect of financial knowledge I wish I had known during that year. At the time, other than making sure I set a proper budget and didn’t spend too much money during my year off, I didn’t really plan for much else.
After I started pursuing a career in financial planning and learned about Roth conversions, I realized that I had missed a great opportunity to save money on taxes. When my income was temporarily low during those tax years when I wasn’t working full-time, I should have converted part of my IRA into a Roth IRA since I was in a lower tax bracket.
The idea is that when you’re in a high tax bracket, you want to contribute to a Traditional 401 (k) or IRA to get the current tax deduction. Then when you’re in a lower tax bracket in the future and withdraw from your IRA during retirement, you pay lower taxes on the amounts you withdraw. But anytime between now and retirement age, you may occasionally find yourself (whether by choice or involuntarily) with lower or no income. During those years you can take advantage of Roth conversions and pay a much lower tax.
For example, a married couple who are both working may be in the 28% tax bracket. They make contributions to their 401 (k)s and don’t have to pay the 28% tax on those contributions. Many years later they decide to take early retirement at age 62 but don’t plan on taking Social Security benefits until full retirement age at age 66. During those four years, their taxable income will probably be very low or even close to zero. If they have IRA assets, they can choose to convert an amount so they don’t go above the 10% or 15% tax bracket and never have to pay taxes on future earnings in the Roth. This is especially advantageous for those who have sizable IRA accounts and will have to take large required minimum distributions when they reach age 70 ½, which pushes them into a higher tax bracket.
An important key to doing a Roth conversion is to make sure that you have sufficient cash outside of the IRA to pay taxes on the amount you convert. Because all future earnings in a Roth IRA are tax free, you don’t want to reduce the amount you convert by paying taxes with your IRA.
Before doing Roth conversions, it’s a good idea to discuss with your accountant since he or she should have the best understanding of your personal tax situation. You can then weigh the benefits (converting at a lower tax rate and never paying taxes on future withdrawals) and costs (paying taxes now and using up cash) of doing a conversion and decide if it makes sense for you over the long run.