3 Reasons to Wait Until You Retire to Make a Roth Conversion

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

One of the most common Roth IRA questions I’m asked is, “Should I make a Roth conversion?” While Roth conversions can make sense at any age, depending on your particular circumstances, generally speaking, the younger you are, the more it makes sense.

Converting at a young age gives you the longest amount of time to let your money grow tax-free and, chances are your retirement account balance is lower earlier in life than as you get close to retirement, so the cost of converting may be less. Here’s the rub though, general advice is only right, in general. It does not apply to all situations and may not apply to yours. Maybe a Roth conversion would be better for you when you retire instead of while you’re young. How would you know? Well, there are
 many factors to consider, but here are three reasons why that might make sense.

1) Your Income May Be Lower
This is probably the most obvious reason you might consider waiting until you retire to make a Roth IRA conversion. When you convert an IRA, 401(k) or other eligible retirement account to a Roth IRA, you have to add the converted amount to your income for that year. If you’re already in a pretty high bracket, any income you generate from a Roth conversion is going to be taxed at that rate or even higher. Adding more income might not be very tax efficient. Consider the following example:

You and your spouse both work and together, you have $200,000 of taxable income. That puts you towards the upper edge of the 28% tax bracket. Now imagine you have $100,000 that you would like to convert to a Roth IRA. If you do so, your income will now be $300,000, pushing you out of the 28% bracket and well into the 33% tax bracket. You’ll also find that now some or all of your investment income, like interest and dividends, is subject to an additional 3.8% surtax, making your top real rate about 36.8%. Ouch. In this case, waiting until you retire and have less overall income may provide valuable tax savings.

2) Your Expenses May Be Lower
Roth IRA conversions usually don’t make sense if you have to dip into your tax-deferred retirement savings or the potentially tax-free Roth you’ve just created to (help) pay for the conversion. The math simply doesn’t add up. That means that in order to make a Roth conversion worthwhile you generally need to have enough outside money (i.e., cash in the bank, money invested in a taxable account) to pay the tax on the conversion.

The problem with that, however, is that while you are still working your expenses tend to be higher. Between the direct costs associated with your job, like commuting, the costs associated with starting and raising a family (more likely to have during your working years) and the savings you’re already diverting each year into an IRA or 401(k) (which generally does not make sense to reduce to pay for a Roth conversion), you may have little or no cash flow to save elsewhere and/or use to pay the tax on a Roth conversion.

By the time you reach retirement age, however, many of the big expenses you had while you were younger may be gone. For instance, you’re less likely to be saving or spending for a child’s education and you’re more likely to have finished paying off a mortgage. Eliminating those two expenses from a budget, alone, could free up tens of thousands of dollars in cash flow that can be re-diverted to savings and, ultimately, used to help pay the tax on a Roth IRA conversion.

3) A Change In Scenery May Be Good For You … Tax-Wise
Oftentimes, people end up moving after they retire. Some move right away, while others wait several years. Of course, there are others that stay put and never move, but for those that do, the move – in my experience – is typically due to one of two main factors; a more comfortable climate and/or a lower cost of living. One of the biggest cost-of-living factors is taxes and, as it just so happens, many of the states that are climate-friendly for seniors are also tax-friendly for seniors. Florida and Texas come to mind as primary winners here, due to their warm weather and the fact that they have no state income tax, but those are extreme examples. You could simply move from a high-income-tax-state to a low-income-tax-state for some tax savings.

In either case, if you make a Roth IRA conversion after you move, you’re bound to lower – or eliminate entirely – the state income tax you’d owe on that conversion. In other words, you can contribute to an IRA, 401(k) or other retirement plan while you are working in a high-income-tax-state, possibly getting a deduction (check your state rules) and allow that money to grow tax-deferred until you retire. Then, when it’s time to take the money out – or make a Roth IRA conversion – you can be in a low or no tax state and minimize your tax liability. This can be such a big deal that I know of some people who moved to a state just so they wouldn’t have to pay income taxes on large Roth IRA conversions.

These are three very good reasons to wait until you retire to make a Roth conversion, but there are many reasons not to wait. Remember that when you retire, your tax-deferred retirement savings is likely to be higher than in younger years. A Roth conversion could trigger more tax on your Social Security. It could increase your Medicare Part B premiums. It could… you get the point. The decision of if, and when, to convert is complicated and varies substantially. Always make sure you’re making your decisions based on your facts and circumstances and not on some general advice. Remember, general advice is only generally right