A Roth conversion involves a tradeoff between the income tax you’ll pay on the amount converted and the income tax you would otherwise pay later on withdrawals from a traditional retirement account. This post is the second in a series on how to compare the conversion tax rate with the anticipated tax rate on withdrawals, or ATRW. The previous one explained why the appropriate comparison is between the lowest rate that applies to conversion income and the highest rate that applies to withdrawals in retirement. The focus this time is on predicting the tax bracket that will apply to withdrawals, especially for people who are still working and more than a few years away from retirement.
If you’re like most people, earnings from your primary occupation are your main source of income, and most or all of that income will go away when you retire. In that case it’s reasonable to anticipate a lower tax bracket in retirement. That’s a negative factor in weighing the choice whether to convert. In a later post I’ll explain how you may still come out ahead with a conversion, at least in some situations. For now let’s look at some of the reasons your tax bracket in retirement may end up being higher than you expect.
Our book on Roth IRAs and other Roth accounts
Working in “retirement.” We think of retirement as that period of life after we’ve stopped working for a living. Yet there’s been a broad trend toward more people working at least part-time after retiring from their main occupation. Some find that they need the income, while others discover they want to do something more rewarding than learning to get up and down from a greenside bunker. Whatever the reason, many people who thought retirement would bring an end to their earnings from employment end up learning otherwise.
Retirement plan distributions. Retirement accounts you don’t convert may grow large enough so that disttributions push you into a higher tax bracket than you currently expect. That’s hardly a misfortune, but it’s a possible reason you might end up wishing you had converted at least part of that account to a Roth before that growth occurred.
Social security. Don’t forget to take into account the rules that require many people to pay tax on a portion of the social security distributions they receive in retirement.
Other income and deductions. Will you have income from investments outside your retirement account? Pensions, or any other form of deferred compensation? Will you lose deductions that keep you in a lower tax bracket when you pay off your mortgage or retire to a state without an income tax?
Life and death. Your tax bracket may change for other reasons. Divorce or the death of a spouse may deprive you of the relatively generous tax brackets provided for married individuals filing jointly. And forgive me for mentioning this, but your own death may cause your retirement account to be taxed at a higher rate, whether you leave it to a surviving spouse who has to file single or to beneficiaries in a younger generation who may be faced with required minimum distributions during their peak earning years.
Life is full of surprises, and one of those surprises could be a higher tax rate in retirement than you currently anticipate. This is one of the many considerations that may go into a decision whether to convert a traditional retirement account to a Roth.
Related
Go Roth! (our book on Roth IRAs and other Roth retirement accounts)
Guide to Roth Accounts (our free online guide)
Tags: feature, Roth conversion, tax brackets
