If you could choose any retirement account to have your assets in, a Roth IRA would likely be at the top of the list. Tax-free growth and a lack of required minimum distributions are a couple of the reasons we have previously highlighted for why to invest in this type of account. To get more funds into a Roth IRA, investors may want to consider a Roth conversion, where assets from a traditional IRA are converted to a Roth IRA. In this article we cover the benefits and considerations retirement savers should think about when looking at this planning strategy.
What is a Roth Conversion?
In a Roth conversion, an investor with a traditional IRA account takes funds from that account and rolls them over to a Roth IRA. When this happens, ordinary income taxes are due on the amount of the conversion for that year (assuming the original contributions to the traditional IRA were pre-tax). Unlike regular contributions to a Roth IRA, there is no income limit for who can do a Roth conversion and there is no limit to how much you can convert.
Why Do a Roth Conversion?
With the Roth IRA’s attractive tax treatment, there are numerous reasons why you may do a Roth conversion:
Expectation of Higher Tax Rates in the Future
When looking at a Roth conversion, a key consideration is what you think your tax rate may be in the future. In doing a conversion, you are paying taxes on the conversion amount now as opposed to paying taxes on this amount at a later date.
An expectation of higher rates in the future could be due to a change in your personal tax bracket or due to an increase in tax rates across the board. You may be in a low tax bracket this year due to lower business earnings or you may expect a higher tax bracket in the future as your career progresses. In both cases, paying taxes now may result in a higher after-tax distribution amount in the future.
Another situation to consider is if one spouse passes away before the other. If the widowed spouse changes from a joint filer to a single filer, they are subject to higher tax rates. Doing a Roth conversion would allow tax on the funds to be paid during a time when the investor is filing jointly at potentially lower rates.
Building up a significant Roth IRA balance can allow for more financial flexibility in the future. For example, if you had a large cash need in the future but didn’t want to pay a lot in extra taxes, a Roth IRA could be a good source of cash. Also, if you wanted to lower your taxable income in an upcoming year for tax planning purposes, you could take funds from your Roth IRA to meet cash flows needs that year.
If your heirs inherit your IRA, it can be more advantageous to inherit a Roth IRA than a traditional IRA. The current laws around inherited traditional IRAs, require that the full account is distributed within 10 years of receiving the funds. This can result in significant taxable income for the new account holder. On the other hand, owners of an inherited Roth IRA do not increase their taxable income since the distributions are tax-free.
What Factors Should Be Considered When Doing a Roth Conversion?
Impact on Taxable Income for the Year
When you do a Roth conversion, you are increasing your taxable income for the year in which it takes place. This could impact other costs for retirees, such as your Medicare surcharge and how much of your Social Security benefit is taxable. Also, if you realize capital gains during the year, it could impact what tax rate those gains are taxed at. Therefore, it is important to look at your overall financial picture when considering a Roth conversion.
Do You Have Outside Funds to Pay the Taxes?
To maximize the impact of your Roth conversion, it is preferable to pay the taxes on the conversion with outside funds. Paying the taxes from this source allows you to increase the amount of funds in the Roth IRA account and maximize the benefit of the long-term, tax-free growth.
Qualified Charitable Distributions
If you plan do a significant amount of Qualified Charitable Distributions (QCD) from your traditional IRA to meet your required minimum distributions, there may not be much value from doing a Roth conversion. Since the QCDs avoid taxes, converting to a Roth IRA may result in paying unnecessary taxes.
Recent Market Conditions
Although Roth conversions can be compelling at any time based on your planning strategy, a market decline could present a particularly opportune time to do a conversion. With a fall in the price of an investment, the tax cost to convert the same number of shares also declines. Hopefully, this would allow for untaxed gains as the investment rebounds in value, although the future performance of an investment is uncertain.
Roth conversions are a powerful planning tool that can meaningfully increase the after-tax value of your investments. To determine if now is the right time to do a Roth conversion, numerous factors need to be considered and it is important to take a long-term view of your financial picture. If you would like to talk about how a Roth conversion may fit into your financial plan, please schedule a call with us here.