There’s a lot written about converting a traditional IRA to fund a Roth IRA, and with good reason.
The benefits of owning a Roth IRA are nothing short of amazing. A Roth grows without any taxes and all amounts withdrawn are tax-free.
The problem is that it’s difficult to get money into a Roth. That’s because you have to pay taxes today on the amount you choose convert from a regular IRA.
The taxes are due in the year you convert at your regular income-tax rate. If you move a large sum all at once that can bump you into a higher tax bracket.
Converting in smaller amounts for several years is a wise move, but even then your income will be higher every year. Because taxes are progressive, you end up paying your highest personal tax rate on those converted IRA dollars.
Roth ‘sweet spot’
For that reason, people often go online and use a Roth IRA calculator to try to figure out if converting is worthwhile for them.
Yet Roth calculators can be of little use. You have to know your tax rate in the future, which is difficult to estimate. Tax rates could rise or fall, and your future income might be more or less than you expected.
What can you do to get the biggest bang for your buck? Plan today to hit the “Roth sweet spot.”
This is when an individual has stopped working, is not taking Social Security, and income has dropped to close to zero. Sometimes there is income from dividends in a taxable account or rental property, but broadly speaking they’ve hit a dramatic income trough.
Naturally, their income-tax rate dives just as dramatically.
This is a wonderful opportunity to take advantage of converting to a Roth before one turns 70.
Why 70? Because after that age the government forces us to take money out of traditional IRAs and 401(k) plans and pay income taxes on those withdrawals.
This is known as a required minimum distribution (RMD) and it happens every year after age 70½, increasing each year.
Tax-rate trough
For people in their early 60s but not yet 70 who are in an income trough, I suggest working with their CPA to suggest an appropriate amount to convert year by year.
This can result in hundreds of thousands of dollars in a Roth IRA by the time one turns 70.
An extra bonus is that, after 70, owners of Roth IRAs are not required to make yearly RMDs on those contributions, unlike with a traditional IRA.
So now they have money that is literally tax-free forever, will grow tax-free forever, and which is not subject to IRS distribution rules.
Anyone who is in this situation in their 60s should carefully consider this strategy to fund a Roth IRA while they are in an income and tax-rate trough.
Hitting the “Roth sweet spot” can make a huge difference in your retirement lifestyle and your legacy — everything that matters financially in retirement.