Pay attention to the tax rate now and the expected tax rate in the future
Dear Dan,
I found your column “Do Roth IRA conversions still make sense with the passage of the GOP tax law?” very helpful and I better understand the strategic choice a conversion to a Roth IRA represents. My question is not about why or how, but when the best time is to convert. Is it early in the year, late in the year, or as one person suggested to me, whenever the market declines? Where do you stand on this?
—Considering Conversions
Dear Considering Conversions,
There is no universal best time during a given year.
It can be a good time to consider a conversion when the market drops because if whatever is in the Roth IRA recovers along with the market, you get more growth in the Roth IRA and if all the rules are followed that means more money tax-free down the road. However, a market drop, in and of itself, is not a good reason to convert. The tax rate issue is still the dominant factor.
Roth conversions pay off when the tax rate applied to the conversion is less than the tax rate that would apply when funds are withdrawn from the traditional IRA in the future. The bigger the difference in those two rates, the better.
For example, say you have a good job with a steady salary that would have you pay a 35% tax rate on any amounts converted this year but when you retire in a few years and no longer draw that salary, you anticipate you would be in the 22% bracket on any distributions from a traditional IRA. The level of the market is immaterial to the decision. You should not convert and pay 35% when you can wait until retirement to pay only 22%.
As for converting early in the year, many view this as the best choice because the money has all year to earn something while in the Roth. That’s true but your investments could drop too. Moreover, you must consider the possibility that your income for the year could rise. I’ve seen people get laid off, think they would have a low-income year, convert a bunch of money to a Roth IRA, only to get a job and end up in a higher tax bracket.
I’ve seen it happen with year-end bonuses, higher than expected earnings from investments or capital gains, sales of property, and even getting married to a high earner. Obviously, a higher than expected income is not a what most would call a problem, but it can make a Roth conversion less effective.
As a result, generally, many find it preferable to wait until late in the year to complete a conversion. At that point you are using actual interest, dividends, salary and other income received rather than estimates of those items to determine the amount to be converted. This presents the opportunity to dial in the exact dollar amount to convert with more confidence there won’t be any surprises and that amount will get taxed at a low rate.
That said, timing is not an all or nothing proposition. You can make as many conversion transactions as you like during the year. You can make an estimate of what you want to do for the year and convert some early, then wait until later in the year to see if more conversions make sense.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Originally published on MarketWatch. Read the original article here.