How to Know If the Time Is Right to Convert a Roth IRA
A Roth IRA is a top-tier retirement savings vehicle. Especially for young people , this is the best way to take full advantage of compound interest while minimizing tax risks. Simply put, with a Roth IRA, you pay taxes on your savings right now. This can be compared to traditional IRAs, where you pay taxes later. We’ve written more about the differences here , and overall I lean toward Roth over traditional approaches.
With Trump-era tax cuts set to expire in 2025, now may be a strategic time to take advantage of that “pay your taxes now ” element. Let’s find out whether a Roth IRA conversion might be a smart move for you.
Why Consider a Roth IRA Conversion Now?
The Tax Cuts and Jobs Act of 2017 is set to expire at the end of 2025 unless Congress renews it. Without action, tax rates will return to the higher levels of 2017 and earlier. This means that switching to a Roth IRA now, although tax rates are relatively low, can result in significant long-term tax savings.
Anyone with a retirement account , such as a 401(k) or traditional IRA, can convert to a Roth IRA. This option is available regardless of income level, making it an attractive strategy for high-income individuals who cannot qualify for direct Roth IRA contributions. As always, the main benefit of a Roth IRA comes down to future tax-free withdrawals. This is a smart account for those who expect to be in a higher tax bracket in the future (which is most people).
Is a Roth IRA Conversion Right for You?
Regardless of the 2025 deadline, consider whether a Roth upgrade is right for you.
1. Current and expected future tax rates. If you expect to be in a higher tax bracket when you retire, a Roth conversion may be beneficial.
2. Time horizon: The longer you have until retirement, the more time your Roth IRA has to grow tax-free.
3. Ability to pay taxes. Can you afford to pay taxes on the conversion without using the funds from the retirement account itself?
4. Estate Planning Goals: Roth IRAs can be an effective tool for transferring tax-free assets to heirs .
Other things to keep in mind
While a Roth conversion can offer benefits, it is not without its challenges.
1. Immediate tax liability: The converted amount is treated as taxable income in the year of conversion, which may result in you now being placed in a higher tax bracket.
2. Five-Year Rules: Roth IRAs have several “five-year rules,” which require funds to remain in the account for a minimum period before they become fully tax-free. This could complicate matters for those planning to access their pension funds soon.
3. Uncertain tax situation in the future. As I mentioned above, making a significant financial decision based on speculation about future government actions carries inherent risks.
Moreover, these mistakes should be avoided when using a Roth IRA . Given the complexities associated with a Roth IRA conversion, it is recommended that you consult with a financial advisor who specializes in retirement planning.
Bottom line
While the potential expiration of current tax rates in 2025 has brought Roth IRA conversions into the spotlight, it is critical to approach this decision carefully. A Roth conversion can offer some people significant benefits, but it is not a one-size-fits-all solution. By carefully considering your unique financial circumstances and seeking expert advice, you can make an informed decision about whether a Roth IRA conversion fits your long-term financial goals.