Is A Roth Conversion Right For You? 7 Things You Need To Know

We’ve been talking to several clients about doing a Roth Conversion before year-end. For some people, a Roth Conversion can be a great tax-saving strategy, but for others it could go down as a big mistake.

Here’s some of the most common misconceptions about Roth Conversions, and what you absolutely need to know before you pull the trigger.

#1 – What’s a Roth Conversion?

The name alone is a little misleading. It’s all about converting assets from a Traditional IRA to a Roth IRA (so shouldn’t it be called an IRA Conversion?) When you do a Roth Conversion, you withdraw assets from a tax-deferred retirement account (like a traditional IRA), pay the income taxes, and then put the assets back into a special retirement account (the Roth IRA) so your money can continue growing tax free.

#2 – Why would you want to do that?

Good question. Why would you ever pay taxes sooner rather than later? That goes against the normal objective of wanting to delay taxes as long as possible. Here’s the answer. You want to pay taxes now because you think your tax rate, or tax rates in general, will go up in the future. You would rather pay taxes now at a lower rate, than run the risk that your taxes could be even higher in the future. In the meantime, your converted assets can grow inside of a retirement account (a Roth) until you ultimately withdraw them tax-free down the road in retirement.

#3 – So how do the taxes work?

Simple. Here’s an example. Let’s say you convert $10,000 in cash or assets from a Traditional IRA to a Roth IRA. That $10,000 withdrawal will be added to your tax return as taxable ordinary income. It wull have roughly the same income tax impact as if you earned $10,000 more in salary. Just to be clear: when you do a Roth Conversion, you are effectively “prepaying” taxes. Some people are super excited about the idea of doing a Roth Conversion until they learn it means paying tax NOW. Sorry; there’s no way around that.

#4 – So is it a good idea to do a Roth conversion?

That depends on your current and future estimated tax rates. To truly make sense, your tax bracket NOW should be lower than what you think your tax bracket will be in the future, either because you think your income will grow in future years, or you think prevailing tax rates will inevitably climb.

#5 – What are some typical scenarios that might put a Roth Conversion at the top of your to-do list?

Here’s several possibilities.

  • You expect your 2020 income be to lower than usual. For example, you worked only part of the year due to early retirement, you lost income due to the pandemic, you waived the normal Required Minimum Distributions from your IRA, or you have significant deductions or losses that will reduce your taxable income (check with your tax advisor).
  • You’ve already retired, but haven’t yet started taking Social Security or required IRA distributions. Once you do, your tax bracket will spike. You want to take advantage of being in this lower-bracket “tax trough” by siphoning money from your IRAs and moving it to tax-free Roth accounts.
  • You’re about to move from a low tax state like Florida to a high tax state, which will significantly increase your future tax bracket.
  • Most or all of your assets are housed in taxable retirement accounts and you want to even out your retirement picture by building up assets you can tap without incurring a huge tax bill.
  • You are at the bottom of your tax bracket, and can take additional income without pushing yourself into the next tax bracket.
  • The market hits a low point, allowing you to move out assets when values are depressed.
  • Your sizable IRA assets will pass to your kids at your death. Fortunately, they’ve been financially successful in their careers. Problem is, their tax bracket is even higher than yours. You’ll do better paying the taxes now and leaving them tax-free money in Roth IRAs, with them named as beneficiaries.

#6 – What are some additional tips?

  • A Roth Conversion normally makes the most sense if you have funds available outside your retirement accounts to pay any taxes due.  If you have to take money out of your IRA to pay the taxes, you’ve already lost ground.
  • You’ll have better luck with a series of smaller conversions over time rather than just one enormous conversion. I’ve found that people who do huge conversions usually regret it later, either because the market doesn’t do what they expected, or tax rules change. There are no more do-overs with conversions, so proceed carefully. Consider doing modest conversions year-after-year so you have more control over the results.
  • And of course, always involve both your financial and tax advisor and get their blessing before proceeding.

#7 – Do any penalties or income taxes apply once I’ve completed the Roth Conversion?

Excellent question, and there is a wrinkle or two. While you can withdraw Roth contributions at any time without tax or penalty, the rules are different for Roth Conversions. Special rules apply. “When a traditional IRA is converted to a Roth account, owners who are under age 59½ must wait five years before they can take penalty-free distributions of funds that were taxable when converted (assuming no exception to the 10% penalty applies),” says IRA-guru Ed Slott.

Plain English translation: you’re in the clear once you are age 59½ or older. If younger, you need to wait 5 years or qualify for an exception to get penalty-free access to your money right away. Talk to your advisor.

About Mari Adam

Mari Adam, Certified Financial Planner™ has been helping individuals and families chart their financial futures for over twenty-five years. Have a question about your financial situation? Ask Mari!

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