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Roth Conversion: A Super Smart Move for Grad School

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Taking time off to go to graduate school often means dropping out of the workforce to live on almost nada income for a while.

However, there’s a silver lining to these lean times when it comes to retirement planning: These low-income years can be used to do some tax-smart maneuvers that can save you money down the road.

If your annual income is more than zero in a year but less than $10,000, and you have savings in a 401(k) from your pre-grad school employment, the time is right to convert those funds into a Roth IRA, according to many financial advisors.

Let’s dig into why and how you might consider doing this.

Why do a Roth Conversion?

A Roth IRA is a kind of retirement savings account that many financial advisors like because of its tax benefits.

It’s different than other retirement accounts such as a 401(k) or traditional IRA as contributions to a Roth are made with after-tax dollars instead of pre-tax dollars. That means when it’s time to use this invested money in retirement, your income taxes have already been paid.

Converting money from your other retirement accounts to a Roth can help you lower your tax bill in retirement if you think your tax rate will be higher in the future than it is at the time of converting. And if you’re going to grad school, there’s a healthy chance that will be true for you.

“This may be a perfect time to convert your IRA rollover account to a Roth.”

“If you are planning to go to grad school full time, you theoretically should be in a near-zero or low-income tax bracket,” says financial advisor Anjali Jariwala, founder of FIT Advisors in Chicago. “This may be a perfect time to convert your IRA rollover account to a Roth. You can take advantage of tax-free distributions in the future by paying minimal tax now.”

You Don’t Have to Convert All at Once

Even converting just part of a traditional account could be good a tax move — the idea is that you’re taking advantage of your low income today to save money on taxes tomorrow.

If your 401(k) or traditional IRA account has a substantial amount of assets, individuals can spread the conversion out over a few years rather than doing it all in one year, Jariwala says.

“For example, you are planning to go to grad school for two years and have a traditional IRA account balance of $14,000,” she says.  “For an individual, income under $9,226 is taxed at 10 percent. To stay within the 10 percent tax bracket, you can convert half of the IRA in your first year of grad school and convert the remainder in your second year. That income is taxed at 10 percent and when you retire, the distributions will come out tax-free.”

One Word of Caution for Financial Aid

If you are thinking about converting some or all of your 401(k) or traditional IRA to a Roth IRA, take the time to do research on what your income and tax rate will be for the year and learn more process around conversion to a Roth.  Also, be sure to read the IRS guidelines for a Roth conversion.

If you are obtaining any financial assistance based on low income, your taxable income inflates the year you convert, says Catherine Seeber, a principal at Wescott Financial Advisory Group LLC in Philadelphia, Pa. That could diminish your chances of financial assistance in the following years.

Already Graduated?

Even if you’re now out of school and back to regularly scheduled income, investing in a Roth is still a good idea — in addition to your 401(k) savings. An individual under the age of 50 can contribute up to $5,500 per year into a Roth on an annual basis.

“I’m a huge fan of the Roth IRA even for those not in grad school,” says Thomas Balcom, founder of 1650 Wealth Management in Lauderdale-by-the-Sea, Fla. “The biggest reason is the tax-free withdrawals during retirement.”

For example, if an individual withdraws $10,000 from a traditional IRA and $10,000 from a Roth IRA, they would need to account for taxes for the traditional IRA withdrawal, while the Roth withdrawal is tax-free.

Conquer your student debt. Refinance now.

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Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.