As a firefighter, your career likely offers a pension that provides stability during retirement. But for those of you with additional savings options, such as a 457(b) or even a Solo 401(k), you may be wondering when you should convert your traditional contributions to Roth–if ever.
Roth accounts allow your investments to grow tax-free, don’t come burdened with Required Minimum Distributions, and don’t affect your taxable income. So why wait? Well, there’s more to it than just converting and saying hello to the tax benefits. The decision comes down to your current and future tax situation, the timeline before you need to access the funds, and even the stock market’s condition. Essentially, timing is just as important, if not more so, as the conversion itself.
This article breaks down when it might make sense to convert to a Roth account and when you might be better off sticking with your current retirement strategy.
Understanding Roth Conversions
A Roth conversion involves moving funds from a pre-tax retirement account, like a Traditional 457(b), into a Roth account, such as a Roth IRA. This process requires you to pay taxes on the converted amount now in exchange for tax-free withdrawals later. The key considerations revolve around timing, tax implications, and your individual financial situation.
The Case for Early Conversion
Longer Time Horizons
The further you are from retirement, the more advantageous a Roth conversion can be. With a longer investment horizon, your money has more time to grow tax-free, potentially offsetting the initial tax hit from the conversion.
One key factor to consider is the break-even point—when the tax-free growth of your Roth account surpasses the upfront taxes paid during conversion and the potential taxes on future withdrawals. The timeline to reach this point depends on your tax rate at conversion, future tax rates, investment growth, and withdrawal strategy. If the break-even point is too far away and you need access to the funds sooner, it might be worth reconsidering the conversion.
Using the chart below, you can see that the Roth account begins outpacing the Traditional account once a higher tax rate kicks in on any potential conversions. For the first ten years, we assume a tax rate of 12%; after year ten, the investor jumps up a tax bracket, and any further conversions would be taxed at 22%. This assumes both accounts experienced equal gains.
However, this doesn’t tell the whole story. For example, other income sources could push you into a higher tax bracket at any point in time, rendering an otherwise sensible conversion into an unsavvy financial move. Since Roth withdrawals aren’t considered taxable income, they help you keep your overall income lower, potentially keeping you in a lower tax bracket.
Low Tax Bracket Years
If you find yourself in a year where your taxable income is unusually low—perhaps due to unpaid leave, reduced overtime, or other factors—it might be an opportune time to convert. Imagine that you’re usually in a 22% tax bracket, but your spouse lost their job and took a while to find a new one, resulting in a temporary drop to the 12% tax bracket. You could convert just enough to remain in that 12% tax bracket.
Market Downturns
At the time of writing, the S&P 500 is enjoying record highs. However, we shouldn’t assume the stock market will always rise steadily. When the market experiences a significant drop, like it did in 2008/2009, it might be a smart opportunity to convert assets to a Roth IRA rather than trying to time the market.
For example, let’s say you own an ETF worth $500, and its value drops by half over a few months. The future is uncertain—it could drop further or recover quickly. Instead of selling and hoping to buy back at a lower price, you could convert the ETF to a Roth IRA while its value is down. This way, you benefit from tax-free growth if the market rebounds, and you’ll likely pay less in taxes now than you would in retirement when you would owe taxes on withdrawals.
Reasons to Hold Off on Conversion
Nearing Retirement
If you plan to retire within the next five years, converting to a Roth could be risky and even endanger your retirement. The five-year rule stipulates that you must wait five years after each conversion before withdrawing those converted amounts penalty-free if you’re under 59½. Withdrawing earlier could incur a 10% penalty on the converted amounts. Additionally, earnings withdrawn before age 59½ and before the account has been open for five years may be subject to taxes and penalties.
You Earn Too Much Money
As of 2024, if your modified adjusted gross income (MAGI) exceeds $146,000 for single filers or $230,000 for married couples filing jointly, you are not eligible to contribute directly to a Roth IRA. That’s where Backdoor Roth Conversions come in.
Basically, you contribute to a Traditional IRA, then convert those funds to Roth. While this is perfectly legal, it complicates the process because the pro-rata rule applies during backdoor Roth conversions.
This rule means that if you have both pre-tax and after-tax contributions in any IRA, the IRS requires you to pay taxes on a portion of the conversion based on the ratio of pre-tax to after-tax funds in all of your IRA accounts.
Let’s say you have:
- $40,000 in pre-tax contributions and earnings in a Traditional IRA.
- $10,000 in after-tax contributions (non-deductible).
If you convert $10,000 to a Roth IRA, you can’t simply convert the after-tax contributions tax-free. The IRS requires you to apply the pro-rata rule.
- Total IRA Balance: $50,000 ($40,000 pre-tax + $10,000 after-tax).
- Percentage of After-Tax Contributions: $10,000 after-tax / $50,000 total = 20% of the total IRA balance.
- Taxable Portion: Since only 20% of the IRA balance is after-tax, 80% of the $10,000 conversion will be taxable.
- Tax-Free Amount: 20% of $10,000 = $2,000 (the after-tax portion).
- Taxable Amount: 80% of $10,000 = $8,000 (the pre-tax portion).
So, in this case, $8,000 of your conversion will be taxed as ordinary income, even though you’re trying to convert after-tax contributions.
Because of these factors, you may find that a backdoor Roth conversion isn’t worth the added complexity, especially if they are already contributing to other retirement accounts, such as a 457(b), where tax benefits can possibly be optimized without complex conversions.
You’ll Be In a Lower Tax Bracket in Retirement
One of the primary reasons for converting to a Roth IRA is to lock in today’s tax rates in exchange for tax-free withdrawals later in life. But what if you’re likely to be in a lower tax bracket in retirement?
If you expect your income to drop significantly after you retire, you might not benefit from paying taxes upfront now. For example, if you’re in the 24% tax bracket now but expect to drop to the 12% tax bracket in retirement, converting to a Roth could actually result in paying more taxes than necessary. In this scenario, keeping your funds in a traditional IRA or 457(b) might make more sense.
Final Thoughts
Deciding whether to convert to a Roth account brings up some important questions: How will your tax situation change over time? How long until you need to access your savings? Are you taking full advantage of low tax years or market downturns? Does it make sense to spread conversions over a few years rather than a one-time lump-sum conversion? Timing is just as important as the decision itself, and one simple mistake can damage your tax plan.
While the potential benefits of tax-free growth are appealing, you really shouldn’t rush into a conversion without understanding the full picture or without a trusted team of retirement planners by your side. If you have questions about Roth conversions or any other aspects of your retirement planning, Protection Red is here to guide you through the process and help make sure you’re making the right choices for your family’s future.
