Converting from a traditional retirement account to a Roth

Why would you want to convert from a traditional retirement account to a Roth?  In our opinion, the only reason to perform a conversion is to realize a higher final return at the time of distribution, which is an unlikely scenario for most people.

When you convert from an existing retirement account to a Roth, you need to pay taxes on the earnings made in the account, and typically the taxes need to be paid in the year of conversion. That means you’re paying taxes this year, instead of when you take the money out.

That said, you generally want to convert from an IRA to a Roth IRA during a year when your income is lower than usual, such as when you have a period of unemployment, or expect to pay little or no Federal income tax for some reason.  If your family income is normally $105,000 / yr, but you’re unemployed for 4 months, your income drops to $70,000. Especially if you’re a head-of-household, that puts you in a lower tax bracket.   The other case for conversion is when you’re young and don’t earn much money yet. You’re typically in a lower tax bracket that you will be in your 40s/50s/60s.

Even with a lower income, we think this is only a good idea if you expect your tax rate to be roughly the same at retirement as while you’re working. Maintaining post retirement tax stability is typically only for those with a very high net worth (>$2m).  If you expect to be in a lower tax bracket at retirement, than conversion doesn’t make much financial sense. It’s better to pay the tax at retirement than now while you’re still working.

One last tax note about conversions.  Converting to a Roth means you will increase your taxable income for the year. That may bump you into a higher tax bracket, but you will only owe taxes at the higher rate for income above that bracket-threshold.  Examine the IRS tax withholding schedules to determine how much money you can convert without hitting the higher bracket.  Here is the Monthly withholding table for 2014:
2014 IRS Withholding from Pub 15