Is a Roth Conversion Right for You?

Thursday, Aug 12, 2021

Many diligent retirement savers have spent decades putting away money into Traditional IRA’s or Traditional 401k’s/403b’s. The main benefit of these vehicles is tax deferral and the potential to receive a deduction on your taxes for the year in which the contributions are made. With a Traditional IRA/401k, taxes are not due until funds are pulled out of the account, typically in retirement. However, because the funds in these types of accounts have never been taxed, the IRS forces investors to start “RMD’s” or required minimum distributions at age 72. With a Roth IRA/401k, funds also grow tax deferred, but are not subject to required minimum distributions at age 72. With no RMD’s on a Roth IRA, it’s easy to understand why investors would want to perform a Roth conversion, but is it right for you? Let’s take a deeper look at all the pros and cons before you decide.

Traditional Retirement Accounts vs Roth Retirement Accounts

First, it’s important to understand the basics behind Traditional and Roth IRA’s. With a Traditional IRA, contributions may be tax deductible in the year in which they are contributed. There are two factors that determine the deductible nature of your contributions. Those factors are your income and whether or not the individual or individual’s spouse participates in an employer sponsored retirement plan, like a 401k. Funds in traditional IRA’s grow tax deferred until they are taken out and are subject to “RMD’s” or Required Minimum Distributions every year starting at age 72.

With a Roth IRA, investors contribute after tax dollars and do not receive a deduction of any kind in the year they contribute. Allowable contributions to a Roth are income based, and funds inside the Roth grow tax deferred similar to a Traditional IRA. However, Roth IRA’s are not subject to “RMD’s” and will benefit from additional tax free growth. Qualified distributions come out of Roth IRA’s tax fee. The most common ways for distributions to become qualified is if you’re at least 59 ½ years old and your first Roth IRA was opened and funded at least 5 years ago.

What is a Roth Conversion?

Simply put, a Roth conversion is when you take money in a traditional tax deferred retirement account and convert it to a Roth account. In the process of converting, you pay income tax on the amount converted in the year the conversion takes place. However, once the funds are in the Roth, you will never have to pay taxes on those funds again. Up until January 1st 2010, there were income restrictions on who was eligible to take advantage of Roth conversions. Those limitations were lifted due to the Tax Increase Prevention and Reconciliation Act (TIPRA) and since then, Roth conversions have gained a ton of traction, allowing more investors the opportunity for further tax efficiency. In general, most financial advisors and tax professionals would not typically recommend that you accelerate the recognition of taxes. However, given the low tax rate environment that we are currently in, Roth conversions may provide significant benefits for many investors.

How to Know If a Roth Conversion is Right for You

Anyone can do a Roth conversion but not everyone should. Unlike the limitations placed on Traditional and Roth IRA contributions, there are no restrictions for conversions. However, there are still several factors involved that should be kept top of mind in determining if a Roth conversion is right for you:

  • Where will you live in retirement?
    • Generally speaking, if you plan to move to a state in retirement that has a higher income tax than the state you currently reside in, it might make sense to convert at least some of your assets before you move.
    • Watch out for IRMAA! IRMAA, the Medicare Income-Related Monthly Adjustment Amount may create a surcharge in your Medicare part B or D premiums and comes into play for married couples filing jointly with a Modified Adjusted Gross Income (MAGI) of $176k ($88k for single filers.) The tricky part here is that IRMAA is based on your income from 2 years prior. This means that if you are married filing jointly and your MAGI was higher than $176k in 2019, you may have to pay the additional Medicare surcharge for your 2021 premiums.
  • Medicare Surtax
    • Similar to IRMAA, married couples filing jointly with MAGI of $250k or more ($200k for single filers) may be subject to an additional 3.8% Medicare surtax. Just like all distributions from a Traditional IRA, the amount you convert from a Traditional IRA to a Roth IRA is treated as income for tax purposes. Therefore, the conversion is part of your MAGI and may cause you to incur additional taxes/surcharges.
  • How would you pay for the conversion?
    • In general, it typically makes sense to utilize taxable assets to pay for the cost of the conversion versus proceeds from the converted account. This is especially true if you are under age 59 1/2 because the IRS imposes a 10% early withdrawal penalty for proceeds being used from a qualified account to specifically pay for the cost (taxes) of the conversion. Further consideration should be made if there are not enough taxable assets to pay the taxes on the conversion.

When is the Best Time to Do a Roth Conversion?

While there is no blanket answer here, we will typically recommend you look at completing conversions after you stop working, but before you begin taking withdrawals from a tax deferred account, or start receiving social security, pensions, or annuity disbursements. This time period has often been called the “Tax Planning Window” and varies for every individual. For some, this period may span 5-10 years, while for others it may only last 1-3 years. While the “tax planning window” is an ideal time to implement a conversion strategy, it isn’t the only time. Any time period of low taxable income could be a good opportunity to do a Roth conversion. For example, if you’re in between jobs or out on disability due to a sickness or injury. When it comes to Roth conversions, timing is everything as the lower your taxable income is, the less taxes you will need to pay.

Further Considerations

While no one can predict what tax laws will be in the future, it is almost certain they will be higher than they are today. This is partially due to the predetermined finite period of the Tax Cuts and Jobs Act and the fact that taxes are set to revert to their higher levels in 2026 as they were before the TCJA was enacted in 2018. Knowing that taxes are most likely lower now than they will be in the future provides significant incentive for investors to analyze Roth conversions sooner rather than later. Furthermore, given the last 18 months and the amount of resources the Federal Government has deployed to lessen the impact of the Covid-19 pandemic, it’s safe to assume taxes will go up even further to help offset the cost of stimulus programs that were enacted.

Lastly, two very important points to remember:

  • Conversions cannot be undone. If you are unsure about the amount you should convert, check with qualified financial or tax advisor before completing the conversion.
  • There is a 5-year window that applies for each separate conversion before you can take a qualified withdrawal. Withdrawals prior to this time frame are subject to a 10% early withdrawal penalty.

    With the proper analysis, Roth conversions can be an integral part of your retirement plan. We are here to help! Please contact us if you have any questions on whether a Roth conversion is right for you.

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