Five years ago, many Americans watched their retirement savings get crushed by the stock market's meltdown in the wake of the financial crisis. Now that stocks have come back, most investors are faring a whole lot better, and it's showing up in their average retirement account balances.
But one even more encouraging sign is that many investors are taking a key step toward shoring up their retirement finances in a tax-smart way.
The Skinny on Saving for Retirement
Fidelity Investments reported on Wednesday that the average balance across the 7 million individual retirement accounts it oversees hit $81,100 as of the end of 2012 -- its highest level in five years.
More impressively, that balance represents a 53 percent jump from the average balance at the end of 2008, and age groups in or near retirement saw even greater gains of 70 percent to 81 percent from 2008 levels. Average IRA contributions were up 3.1 percent over the past year, and that combined with the market's strong performance have pushed balances up.
But the most surprising news from the Fidelity report was the big surge in Roth IRA conversions at the end of 2012. Fidelity reported 52 percent more Roth conversions in the last month of 2012 than it saw in December 2011. Overall for the year, conversions rose 12 percent.
Why Converting Was Smart
The move toward Roth conversions is consistent with some other tax strategies that gained popularity at the end of last year.
With tax rates scheduled to rise at the beginning of 2013, taxpayers found themselves in the unusual position of wanting to increase their taxable income for 2012, taking the hit while rates were low in order to avoid a bigger tax bill in future years.
Roth conversions provided an easy way for taxpayers to accomplish that goal and lock in tax savings for the rest of their lives.
Under the rules governing Roth conversions, the money you convert gets counted as taxable income for the year of the conversion. But once it's in the Roth, you don't have to pay taxes on the income or gains from investments within the account, even when you take withdrawals during retirement.
Roth conversions have been an option for 15 years, but the appeal dramatically expanded in 2010, when previous income limits on conversions disappeared. Yet during normal tax years, accelerating income didn't make as much sense as it did last year, and so taxpayers haven't always taken full advantage of the Roth opportunity.
Should You Convert?
The most important consideration in deciding whether to convert to a Roth is whether your current tax rate is higher or lower than the taxes you'll pay in retirement.
If you're in a very low bracket now, converting essentially lets you lock in your current tax rates, so you avoid having to pay potentially higher taxes after you retire.
By contrast, if you're in a top bracket, then it becomes much more of a gamble on future rates, as you're betting that paying more than 40 percent in taxes now will be a better deal than what you'll pay in retirement when you take withdrawals from a traditional retirement account.
Another factor, though, is whether you have money outside your retirement account to pay the extra taxes you'll incur. Taking money out of your IRA to pay those taxes makes converting much less attractive, as it incurs a 10 percent penalty and reduces the long-term benefits of the conversion.
It Might Not Be Too Late
With tax rates now at higher levels for many taxpayers, the Roth conversion opportunity that presented itself late last year is now over. But that doesn't mean converting is a bad idea.
To see whether you should convert, run your own numbers and figure out whether the long-term advantages outweigh the potential costs.