First, a quick primer on Roth IRA’s. Unlike a traditional IRA (that can allow for a tax deduction under certain circumstances), A Roth IRA does not have a tax advantage today however, it allows one to reap the benefits of tax free build up over time, take money out tax free (with some limitations), and has no distribution requirements like a traditional IRA or traditional workplace retirement plan. One can leave money in their Roth IRA until they pass away and leave a tax-free account to a loved one.
What Is a Roth Conversion?
A Roth conversion is simply the act of converting a traditional IRA account (Or pre tax workplace retirement plan) into a Roth IRA account. As mentioned above, a traditional IRA account is usually funded using pre-tax dollars, meaning the distributions you take from a traditional IRA account in retirement are taxed as ordinary income. A Roth IRA is created using after-tax dollars, meaning the distributions you take from a Roth IRA account in retirement are tax-free (because tax has already been paid).
Bear in mind, certain rules must apply for this money to come out tax-free.
So, should you be doing a Roth Conversion?
While a Roth conversion could be a great option for some, it could be a costly mistake for others. That’s why I’ve outlined four important considerations to make before converting your traditional IRA into a Roth account.
Consideration #1: Your Timeline to Retirement
If you’re retiring within the next few years, and you think you will need this money to live on soon after, you may want to forego a Roth conversion. Why? Because the money you convert into a Roth IRA really should remain invested for a longer period of time to counteract the tax issue as shown below.
Consideration #2: Tax Obligations
When considering a Roth conversion, you simply can’t ignore the tax implications associated with this move. While your aim may be tax-free income in retirement (or leaving tax free money to a loved one), you will have to pay taxes on the amount converted in the year of conversion. The amount converted will be added to your income as ordinary income. You need to be prepared to pay the taxes on this additional income, which could very well push you up into a higher tax bracket. While it’s possible to pay the taxes from the IRA you are converting, this is typically not advised.
By taking “extra” money out of your IRA to pay the tax, you are paying additional tax as well as having less in your IRA to grow going forward.
Once money comes out of an IRA, it loses its “tax deferral status” if not going into another retirement account. Taking money out of an IRA to cover the taxes is not advised.
Consideration #3: Your Future Tax Bracket
One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement (or to skip taxable required withdrawals in a traditional IRA if the money isn’t needed). With that in mind, you’ll want to take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds. If you believe you’ll be in a lower tax bracket come retirement, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of interrupted or lowered income (lost a job, missed out on a bonus, etc.), you may be in a lower tax bracket now than you would when entering retirement. Since tax rates really have nowhere to go but up in my opinion, This could be a Roth conversion opportunity.
Consideration #4: How Much to Convert and When
If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation. Being out of the workforce could be an opportunity to convert while your income is temporarily low.
Consideration #5: How Much Income You Will Need in Retirement
If for example, you need more than your required minimum distribution from a traditional IRA during retirement to meet your expenses, a Roth conversion might not make sense as this account could be depleted in too short a time to warrant paying those taxes upfront.
The SECURE Act 2.0 recently passed which can provide another opportunity for some thinking about doing a Roth conversion.
Up until recently, the age for those not subject to Required Minimum Distributions (RMD) yet was 72. SECURE Act 2.0 changed all that. Here is the current rules:
- If you were born before 1950, your starting age is 70 ½ (You are already taking these required distributions and must continue to do so)
- If you were born in 1950, your starting age is 72. Same as current law
- If you were born between 1951 and 1959, your starting RMD age is 73
- If you were born in 1960 or later, your starting RMD age is now 75
So, what’s my tip? These later ages buy you some more time to consider a conversion. Why? Well, the latest one can take Social Security is age 70. Before the passing of SECURE Act 2.0, most were also taking a required distribution around the same time. The combined income of SS and IRA distributions could cause one’s overall income to rise above an amount that could cause issues with bumping int a higher tax bracket or being subject to increased Medicare premiums.
Rex is 73, still working and earning over $100,000. He also receives $43,000 from Social Security. He has very little in savings. His RMD this year is $22,000. Should he consider a Roth Conversion?
With an income of around 165,000, not only would a Roth Conversion potentially bump him into a higher tax bracket but would also cause his Medicare premiums to go up. And don't forget the extra money coming from his IRA to pay the conversion tax which could further negate the reasons for a conversion.
Sally, 55, took a year off from working to care for her dad. She is a good saver and has a cash cushion well above her emergency fund.
She could be an ideal candidate to do a Roth Conversion due to her lower income. She has years until she needs to draw on this account and has the cash on hand to pay the tax.
Kisha is going through a divorce. Her assets consist mostly of a very large IRA.
Since her IRA will most likely be split with her soon to be ex, it might be best to wait until after the IRA is divided to consider a Roth Conversion. Paying taxes on a portion of a tax free asset going to her ex is probably something she would like to avoid.
How to Make a Roth Conversion
The IRS offers three possible ways for an individual to convert funds from a traditional IRA into a Roth IRA account. These methods include:
- Rollover: You are given the funds and must put the funds into a Roth IRA account within 60 days.
- Trustee-to-trustee transfer: The institution currently housing your traditional IRA transfers the distribution to a different institution where it'll be held in a Roth IRA.
- Same trustee transfer: The institution currently housing your traditional IRA is able to also house your Roth IRA, and they roll the account over for you.1
Ideally, when doing any movement of retirement accounts, you want to avoid being in the receipt of a rollover check. The trustee to trustee or same trustee option is the most seamless and less likely to end up with an error on the 1099 tax form you will receive.
Being able to withdraw income tax-free in retirement is an appealing option for many. And it’s good to know that while you may have chosen to open a traditional IRA years ago that you have the option to convert it at any time. Before making any moves to your retirement savings account, make sure to speak with your Certified Financial Planner® practitioner and/or your CPA first. Together, you can go over these important considerations in regard to your unique financial situation.
As always, please feel free to reach out to me anytime for a conversation. Click HERE
Check out this other blog article... Do Women Face Additional Challenges Financially? Click HERE
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In good health.
All the best.
Rick Fingerman, CFP®
*This blog article is meant to be just a simple primer. I'm happy to speak in more detail one on one.
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.