Good idea to convert rollover IRA to Roth right now?

[fallstoclimb]

My husband just got quite a large raise that will have us nearing the Roth income limits beginning next year.  We have about 10K sitting in a rollover IRA account that will be blocking us from doing backdoor Roths if they become necessary.  Initially I was planning to see if I could roll this into his 401k with his new job, but now I am thinking we may as well pay the taxes now to convert it to a Roth IRA, sort of as an early Roth ladder.  We are currently in the 22% tax bracket, may be in the 24% next year (although for this amount of money, the difference in taxes is minimal).

We are in our late 30s, plan to retire or coast-fire around 50, it seems likely we will rely on a Roth ladder in the future particularly given that we both have pensions that will kick in later.  Is there anything I'm not thinking of for why this may be a bad idea?

Some of the uncertainty around future income is that my husband's new job pays out a 15% bonus if the company meets its financial goals. We have never had large bonuses before, so I am new to planning around this. Our first financial goal is to stockpile more cash now that one of us has a private sector job, but if we are doing well with cash and if he receives the bonus NEXT year, I am interested in using it to open a donor advised fund which would obviously be a substantial write-off. So, it may be better to do the conversion next year, although I am a bit nervous about all of the uncertainty in this plan and what may happen if we blow past the Roth income limits without having the conversion complete.  Thoughts?

[secondcor521]

First, you are permitted to do a backdoor Roth even with a balance in a rollover IRA.  It does mean you would be subject to the pro rata rule, which involves filling out some tax paperwork on Form 8606 and some (including me) would consider a hassle.  But there's no actual tax penalty for doing things that way and also no tax rule against doing so.  (When I was in a similar situation, I did rollover the rollover IRA into my 401(k) to avoid the paperwork, FWIW.)

If you convert all of the rollover IRA to a Roth this year (or roll it into his new job this year - this assumes it is his rollover IRA) in addition to any backdoor Roth, you won't have to deal with the pro rata rule.

If you're sure you want a Roth ladder at some point, then doing it now at a tax cost of 22% when it sounds like you're going to be in higher brackets for a while - perhaps until you coast FIRE - is appealing.  What might be more appealing, and is an option I would try to investigate in more detail, would be to see if you can build your Roth ladder when you are in that coast FIRE period.  The reason for building the Roth ladder during the coast FIRE period is that you might be able to build it at a tax cost of 15% or so (whatever the brackets revert to or are changed to), which is a significant savings.

It's not clear from your last paragraph, but the Roth AGI limits are only for contributions.  Roth conversions and backdoor Roths can be done at any AGI.

[Sandi_k]

If you're sure you want a Roth ladder at some point, then doing it now at a tax cost of 22% when it sounds like you're going to be in higher brackets for a while - perhaps until you coast FIRE - is appealing.  What might be more appealing, and is an option I would try to investigate in more detail, would be to see if you can build your Roth ladder when you are in that coast FIRE period.  The reason for building the Roth ladder during the coast FIRE period is that you might be able to build it at a tax cost of 15% or so (whatever the brackets revert to or are changed to), which is a significant savings.

I think I am missing something here - Coast FIRE, by every definition I've heard, is that you have saved enough that you don't have to save anything more for FIRE. If that is the case, the OP would be in a HIGHER tax bracket, as there would presumably be no 401(k) savings and reduced taxable income.

If you mean that they would be in the 15% tax bracket once FIREd, and therefore they could convert at that time (with no employment income) that's different.

I would also note that tax brackets are supposed to revert in 2026, to the old brackets. That will be 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.

So it would behoove the OP to make sure that they are unlikely to be in the 25% bracket once FIREd. If there is a possibility that they'd be in the 25% bracket once FIREd, that's another reason to convert all IRAs to Roth now.

OP - FWIW, we converted another big chunk of DH's SEP-IRA to his Roth this year. We are aiming to retire in 2026, and we hope to have all of his IRA converted by then. We are paying the taxes out-of-pocket, through my over-withholding at my W-2 job. We chose to convert at the 22% bracket for multiple reasons:

1) The reversion of the tax brackets in 2026, as noted above.
2) I will receive a substantial pension in retirement, which means I cannot control my income.
3) We currently have more than 90% of our retirement savings in pre-tax accounts.
4) We are trying to ensure our retirement income is below the second IRMAA threshold.
5) Our RMDs will be substantial, once we get to age 74 and 72.
6) The surviving spouse will have shocking RMDs once the first spouse passes.

If any of those reasons are similar to you, then yes - I'd be converting now. The $2200 in taxes on $10k in your current IRA will be more than offset by the bonus, and it will simplify your life in a good way, going forward...

[fallstoclimb]

Thanks to both of you, this is extremely helpful!

Sandi_k, we are much further from our FIRE date from you, but otherwise all of those things will be true for us as well.  I'm a fed and my husband had 15 years with the state prior to this new job, so we should be getting significant pension income in our regular retirement.  60% of our retirement savings is in my TSP, which expect to max every year between now and age 50.

It is hard to say what will happen around 50 - we *may* drop to a lower tax bracket, but the money will have been growing in a pre-tax account, so there will be more to pay taxes on. I think this is where my understanding gets shaky -- if it is better to let it grow pre tax and then pay more taxes upon conversion, or if we should just convert now.  With the bulk of our retirement savings in my TSP, which we will continue maxing for 10+ years, I suspect it doesn't matter so much if we just convert this rollover IRA now.

[Sandi_k]

Yes, then I would convert now.

One other reason to have some substantial funds in Roth:

if you have big bucket list travel planned, or need to do lump sum withdrawals to fund home improvements (yes to both of those items for us!), then having funds in a Roth that can be taken out without tax or IRMAA considerations will be a Very Good Thing.