When a Roth conversion makes sense

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Q. I have an old 401(k), a current 401(k) and a traditional IRA. I have no Roth. How can I decide if I should convert any of the money to a Roth? I earn $70,000 a year.
— To convert or not?

A. The idea of tax-free income in retirement can be tempting.

With a Roth IRA, you can take tax-free distributions at any time after you reach age 59 1/2.

Another added benefit, notes Timothy Brunnock, a financial advisor and attorney with Trinity Financial Strategies in Morristown, is that there is no requirement to take Required Minimum Distributions (RMDs) at age 70 1/2, as would be required with a traditional IRA.

However, he said, Roth IRAs are funded with after-tax money, which means you cannot take the contribution as a tax deduction.

There are income limitations as to when a specific year’s contribution is eligible to go into a Roth, but you can do a “Roth conversion” of existing IRAs at virtually any time.

If you do, Brunnock said, the amount converted in any given year is deemed to be earned income for that year.

He offered this example: If your old 401(k) and your traditional IRA amount to $300,000, you can convert the entire amount into a Roth. The IRS will treat this as if you have earned $370,000 for that year — your $70,000 salary plus the $300,000 conversion.

“In other words, aside from your salary, you would owe regular income tax on the $300,000,” he said. “This will in all likelihood push you up into a higher tax bracket.”

Although you do not mention the amounts of your old 401(k) and your traditional IRA (note your current 401(k) is probably not eligible for a Roth conversion), you may wish to spread out the conversions over a number of years, Brunnock said. This will not only minimize the tax due in any given year, but could also serve to keep you in a lower tax bracket.

“It may hurt to pay the tax now, but depending on your age, it may make sense to do the conversion and enjoy tax-free distributions in the future,” he said. “If you were a farmer, it would be like deciding whether to pay tax on the seed you are going to plant, or pay the tax on the eventual harvest.”

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This post was first published in March 2017.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.