One of the most frequent questions I receive from clients is whether they should consider a Roth IRA (individual retirement account) conversion. As such, I thought it would be a worthy topic for a blog post. Given that I work primarily with people who are nearing or already in retirement, my discussion will be focused mainly on this cohort.
First, for those who need it, here is a quick primer of what a Roth IRA conversion is, in simple terms:
A Roth IRA conversion is a process in which you move money from a traditional retirement account, like a traditional IRA, to a Roth IRA. The main difference between the two is how taxes are handled.
In a traditional IRA, you generally do not pay taxes on the money you contribute to the account. Instead, you pay taxes when you withdraw the money in retirement, or before then if you need to access the funds (although this may result in an additional tax, depending on your age). On the other hand, with a Roth IRA, you contribute money that has already been taxed, so you do not owe any taxes when you take it out (although again, there are timing provisions to be aware of, as discussed below).
During a Roth IRA conversion, you transfer some or all of the money from your traditional IRA (or a similar retirement account, such as a pre-tax/tax-deferred 401(k)) to a Roth IRA. However, this transfer is considered a taxable event. Therefore, you must pay income taxes on the amount you convert (except to the extent that it includes an amount allocable to any prior non-deductible/after-tax contributions you may have made) because you are essentially moving money from the pre-tax bucket to the after-tax bucket.
How would someone potentially benefit from doing this? Well, there are a few ways:
- Tax-free withdrawals: Once the money is in a Roth IRA, any future earnings and withdrawals you make in retirement are tax-free. This can be advantageous if you believe your tax rate might be higher in the future, or if you want to have a source of tax-free income during retirement.
More specifically, the earlier years of retirement, before you are subject to required minimum distributions (RMDs) from pre-tax retirement accounts and/or receive Social Security benefits, both of which are considered taxable income, can be a particularly opportune time to consider Roth IRA conversions, as you may be in a relatively low bracket. An additional benefit of accelerating distributions, and thus reducing the balance of a traditional IRA, is that doing so lowers the amount of taxable RMDs in the future (unlike traditional IRAs, Roth IRAs are not subject to RMDs). A lower traditional IRA balance can also be beneficial for a surviving spouse. This is because the surviving spouse, assuming he or she does not remarry, will file taxes as a single filer instead of as married filing jointly, which can result in higher tax brackets and lower deductions (commonly referred to as the “widow(er) tax penalty”).
Finally, owning a Roth IRA can be advantageous during retirement if you have a year with high expenses and you do not want to take money from a pre-tax/tax-deferred retirement account, which could push you into a higher tax bracket. Having multiple “buckets” to withdraw from during retirement can provide more flexibility in terms of tax planning.
- No RMDs: Traditional IRAs require you to start taking out a certain amount of money each year, once you reach a certain age (currently 73, with this age threshold scheduled to rise to age 75 in 2033). However, Roth IRAs do not have this requirement, so you can leave the money in the account and let it grow tax-free indefinitely during your lifetime.
- Social Security and Medicare flexibility: Doing a Roth IRA conversion prior to starting Social Security and Medicare can be helpful, because future distributions from the Roth IRA can mitigate the tax implications of Social Security and Medicare surcharges.
- Potential estate planning advantages: Roth IRAs can be beneficial for passing on wealth to your heirs. When you leave a Roth IRA to your beneficiaries, they can inherit it without having to take taxable distributions and enjoy tax-free growth (although under current rules, most non-spouse beneficiaries must liquidate the account by the 10th year after the death of the original owner).
While Roth IRA conversions can have significant benefits, it is important to be aware of some potential pitfalls and risks. Here are some key considerations to keep in mind:
- Immediate tax liability: This is an obvious one, as the amount you convert is considered taxable income in the year of conversion. Depending on the size of the conversion, this can result in a substantial tax bill that must be paid from your existing assets, reducing your retirement savings. Thus, it is crucial to evaluate whether you have sufficient funds to cover the tax liability without compromising your retirement income.
Relatedly, you should preferably use money outside the IRA to pay the associated conversion tax; otherwise, you can erode the value of a Roth conversion. It is ideal to use idle excess cash that has already been taxed, residing in either a bank or taxable brokerage account.
- Additional tax-related effects: Realizing higher taxable income may lead not only to a higher tax bracket but also to more taxes on Social Security benefits and higher Medicare means-based Part B and Part D premiums (technically known as the Income Related Monthly Adjustment Amount, or IRMAA). Moreover, if you receive health coverage via an Affordable Care Act (ACA) exchange (for example, because you are retired and no longer have employer coverage, but are not yet eligible for Medicare), higher taxable income can adversely impact your premium subsidies.
Finally, bear in mind that we have addressed only federal taxes thus far. Some states do not tax retirement distributions or have no income taxes at all. So from this broader perspective, the tax impact of Roth conversions can vary depending on one’s state of residence.
- Potential withdrawal penalty: In addition to the upfront tax cost, you should be aware of the so-called “5-year rule.” This rule determines when you can withdraw converted funds from a Roth IRA without penalty. If you are over the age of 59½ at the time of the conversion, you can withdraw the amount of your converted funds without penalty; however, you will still have to wait five years before any earnings on the converted funds can be distributed tax-free.
- Short time horizon: Particularly if you are a retiree with a brief time horizon and do not expect to live long enough to fully benefit from the tax-free growth of a Roth IRA, a conversion may not make sense.
- RMDs and Roth conversions: You should bear in mind that you cannot convert a traditional IRA to a Roth IRA and have the conversion amount counted toward that year’s RMD for the former. In other words, you must satisfy your RMD first before doing a Roth IRA conversion (and thus both would be included in your taxable income for that year).
- Estate planning benefits are not necessarily a sure thing: While Roth IRA conversions can be beneficial from an estate planning perspective, as stated above, the cost of the conversion may not be justified if your beneficiaries are in low tax brackets.
Furthermore, if you plan to leave your traditional IRA to a qualified charity, it does not make sense to do a Roth conversion. As a tax-exempt entity, a qualified charity does not have to pay taxes when distributing assets from a traditional IRA. Thus, by converting, you would be paying unnecessary taxes on the converted amount.
- An irrevocable decision: Although it used to be possible to undo (or, in official parlance, “recharacterize”) a Roth IRA conversion, this is no longer the case due to tax law changes. In other words, once you have made the switch, you are committed to paying the taxes on the converted amount and cannot transfer the money back to a traditional IRA.
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At the end of the day, there is no single right answer for everyone in terms of the value of a Roth IRA conversion. What is ultimately best for you depends on your own individual circumstances, and like most things in life, there are trade-offs that need to be considered. Additionally, you will need to make educated guesses about certain key unknowns, such as your future tax rates (let alone tax rates in general!), potential spending needs, longevity, and more. This is why it can be particularly challenging, and perhaps even futile, to accurately model how much you should convert to a Roth IRA over multiple years into the future. Instead, it is a decision that is likely best made on a year-by-year basis.
If you would like a trusted partner to assist you in making the decision that is best for you, please don’t hesitate to contact me.
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