Why Delaying a Roth Conversion Quietly Costs High Earners $20K Over 10 Years
When it comes to financial management, the worst thing you can do is make bad decisions with your money. The second-worst might be making no decisions at all. That includes deciding when (and when not) to convert your traditional retirement account to a Roth IRA.
For high earners, delaying a conversion during low-income years could end up costing you tens of thousands of dollars over time.
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What Is a Roth Conversion?
Roth conversions are a useful way to take advantage of low-income years for tax benefits. If you have retirement funds in a pre-tax account, you can convert them into a Roth IRA without triggering any sort of penalty, even if you're under 59 1/2. As long as you don't withdraw it for five years, the contributed amounts are yours to take (growth must remain untouched.)
The catch is this is treated as a taxable event, so it's best done in years when you reduce your taxable income in other areas — say, if you're living off savings and investments from a taxable brokerage. It may also be a prudent move in a year when you're between jobs.
With minimal, or even no, tax paid on the conversion, you'll have moved funds into a tax-free account, where it will continue to grow with no further tax burden on you.
There are some risks. Short-term, you could see higher taxes in the year you convert, according to Vanguard.
You’ll also want to pay the taxes out of your savings, since using the pre-tax account to cover tax expenses would likely trigger penalties for anyone under 59 1/2. Plus there's the lost growth of that portion of the funds.
But there are advantages as well, including these cited by Fidelity:
Tax diversification: You might not even want to convert all of your retirement, despite the tax savings. When your money is in both pre-tax and Roth accounts, you have more flexibility to adjust your withdrawals according to your tax strategy for that particular year.
Potential tax savings: Perhaps you invested heavily early in life, when your income was low but your costs of living were lower. If, for any reason, your taxable income in retirement will be higher than when you earned that money, you've got this option to reduce what you'll owe the IRS.
A third advantage, cited by Vanguard, is that a Roth conversion removes the pressure of required minimum distributions at age 72. In pre-tax accounts, the government eventually compels you to begin taking out money, which can force your tax strategy into places you'd rather not go — often by running afoul of Medicare's IRMAA.
With a Roth, your money grows tax-free (after all, you already paid it) until you deem it advantageous to withdraw, not when the law makes you.
Why You Shouldn’t Delay
One of the key reasons you shouldn’t delay a Roth conversion has to do with your income. If you have the opportunity of a low-income year and can afford the tax, you'll move the seed money in for years of untaxed growth. If you wait until later in life, you'll have much more money to move — meaning a higher tax bill either at the conversion or when left in the pre-tax account for withdrawal later.
In fact, low-income years might be “one of the best times” to convert pretax money from a traditional IRA or eligible 401(k) to a Roth, according to Michael Schramm, CFA, a financial writer and founder of Emotional Finance.
The Cost of Delaying
Delaying that conversion could be a costly mistake. As an example, Schramm cited someone who wants to convert $50,000.
“If you convert it while you’re in the 22% federal tax bracket, you could owe about $11,000 in federal taxes,” he said. “If you wait until you’re back in the 35% bracket, you could owe about $17,500.”
That $6,500 difference could be put to much better uses, Schramm said. If the amount earns an average annual return of 7%, its approximate value will grow the following amounts:
10 years: $12,800
20 years: $25,200
30 years: $49,500
When you factor in the additional $6,500 you had to pay in taxes, not converting could end up costing you $19,300 in 10 years alone.
Before making any Roth conversion decisions, Schramm recommends reviewing your financial situation to determine the best course of action — especially if you’re not a high earner.
“It helps to pause and ask whether the tax bill would strain your emergency fund or your ability to cover necessary expenses,” he said. “If so, consider a smaller conversion.”
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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