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What is a Roth Conversion and is it Right for You?

By November 1, 2021September 21st, 2022No Comments

The impact of the pandemic, along with current historically low tax rates, makes 2021 an opportune time to consider converting a traditional individual retirement account (IRA) to a Roth IRA. There are various reasons to consider such a maneuver, but most commonly Roth conversions can be a smart way to help manage tax bills for both you and your heirs.

However, given that the conversion will be permanent — you can’t revert the money back to a traditional IRA – and the money you convert is reported as taxable income, it requires a careful approach that doesn’t unintentionally trigger a huge tax bill in any single year. Your wealth advisor and a tax professional can help you understand the deeper tax consequences of using this potential tax saving strategy.

How does a Roth conversion work?

To understand how a Roth conversion works, it’s critical to understand the nature of traditional and Roth retirement accounts. With a traditional IRA, you don’t pay taxes on the money you contribute, but future withdrawals are taxed as ordinary income. With a Roth IRA, however, the opposite is true: you deposit money on which you’ve already paid taxes, so the money you eventually withdraw in retirement is not taxable.

A Roth conversion is the process of moving funds from a traditional retirement account to a Roth retirement account, allowing you to accelerate the payment of income taxes and withdraw the funds at a future date free of tax.

All income earners are eligible.

While Roth IRA contributions are subject to certain restrictions and income limitations, there are none for facilitating Roth Conversions. As a result, some high income earners who are unable to contribute directly to a Roth IRA may choose a conversion technique often referred to as a “backdoor Roth conversion”. This strategy is a two-step process: First, you place your contribution in a non-deductible traditional IRA — which has no income limits — then, you move the money into a Roth IRA using a Roth conversion.

For those earners who are looking to contribute even more, some employer-provided retirement plans allow for a “mega backdoor Roth” which permits after-tax funds to be contributed above the IRS employee deferral thresholds up to certain limits. Then, if allowed by the plan, you can convert the after-tax contributions to a Roth.

Why convert a traditional IRA to a Roth IRA?

  1. Enjoy tax-free withdrawals in retirement
    Deciding whether to convert to a Roth IRA hinges on issues like your tax rate now versus later, the tax bill you’ll have to pay to convert, and future plans for your estate. A Roth IRA conversion means you pay tax in the year you move your money from the traditional retirement account to the Roth in order to set up a tax-free source or retirement income later in life.

  1. Watch your money grow tax-free for longer
    Traditional IRAs force you to take required minimum distributions (RMDs) every year after you reach age 72 (age 70½ if you attained age 70½ before 2020), regardless of whether you actually need the money. So you lose the tax-free growth on the money you had to withdraw. On the other hand, Roth IRAs don’t have RMDs during your lifetime, so your money can stay in the account and keep growing tax-free.

  1. Leave a tax-free inheritance to your heirs
    If your intention is to bequeath a retirement account, new rules that went into effect in 2020 require most non-spouse beneficiaries to empty an inherited IRA within 10 years, potentially creating adverse tax consequences for your heirs. If a non-spouse beneficiary inherits a Roth IRA, they still need to withdraw all the money by the end of the 10-year window, but they won’t owe any taxes.

Some important questions to answer before converting:

Will you need the money in 5 years or less?

There’s a 5-year holding period on withdrawals of contributions and growth that were part of a Roth conversion. If you think you’ll need the money within that time, you could end up owing the taxes you were hoping to minimize with a conversion.

Will the conversion push you into a higher tax bracket?

All or a portion of the money you convert could be considered “reportable income” by the IRS. If you’re on the cusp of the next tax bracket, there’s a chance you’ll get bumped up in the year you convert. Consider converting a portion of your traditional IRA to stay out of that higher tax bracket and to spread the taxes related to the conversion over a few years instead of getting hit with the entire bill in one year.

Will your tax bracket be higher now or later?

No one really knows how tax rates could change over the next 5, 15, or 25 years, but if you believe your tax rate is lower now than it will be when you start taking withdrawals, a conversion may look promising because you’ll pay conversion taxes while you’re in a lower tax bracket and enjoy tax-free Roth IRA withdrawals later (when the higher tax bracket won’t matter). But, if you believe your tax rate is higher now than it will be when you start taking withdrawals, a conversion could cost you more in taxes now than you’d save with tax-free withdrawals later.

It may help to “diversify” your taxes — in other words, pay some of the taxes now (when you’re still building your retirement savings) and save some for later (when you need that money to cover expenses in retirement).

Medicare Part B premiums are sensitive to your income. Based on the six brackets, if your Modified Adjusted Gross Income (MAGI) from your tax return of two years prior is above certain limits, you could be charged extra premiums that increase your total cost.

Given a Roth conversion will increase your income in a given year, it is important to understand how it might impact your Medicare premiums in future years. For those who are further out from Medicare age, it can be extremely beneficial to develop a strategic Roth conversion plan that spans many years.

Where will you get the money to pay the conversion taxes?

While it can make sense to initiate a Roth IRA conversion when your income is down and you are in a lower tax bracket, a period of unemployment may not be the optimal time to do a Roth conversion if you don’t have enough cash on hand to pay the taxes that will be due on the amount you convert.

And before you use money from your IRA to pay the tax bill, consider the potential consequences. The money taken out of your IRA to pay conversion taxes would be considered a distribution and could result in even higher taxes in the year you convert. In addition, if you’re younger than age 59½ and you withdraw money from your IRA to pay conversion-related taxes, you could also face a 10% federal penalty on that withdrawal. In the long-term, you’ll also lose the chance for that money to compound and grow tax-free in your IRA — which means less money when you need it in retirement.

Consult with a trusted tax professional or financial advisor who can help you navigate all the moving pieces of a Roth conversion. Please reach out to the AdvicePeriod team if there’s any way we can help.