Thinking About a Roth IRA Conversion?

This popular strategy may reduce the amount of lifetime taxes you pay.

June 7, 2021

What is a Roth IRA?

A Roth IRA conversion refers to moving part or all of a traditional IRA or 401(k) to a Roth IRA. It may also be possible to convert a traditional 401(k) to a Roth 401(k), depending on plan design. At the time of conversion, tax is paid on pre-tax contributions and earnings. The Roth IRA then grows tax free, can be withdrawn tax free, and is not subject to required minimum distributions (RMD).

Why Might a Roth Conversion be a Smart Financial Move?

You expect to be subject to higher tax rates in the future.

Perhaps your current income is relatively low, you believe tax rates are going to increase, or you are concerned that large balances in tax-deferred accounts will mean large future required minimum distributions. These are all reasons that a Roth conversion may provide you with lifetime tax savings.

You want to smooth out annual income through retirement.

Income can be lumpy. Uncertain bonuses, layoffs, or inconsistent portfolio income can mean income variability from year to year. Timing of Social Security or pension benefits may also be a factor. A series of partial Roth conversions can serve to redistribute the timing of income and move taxable income to lower tax brackets

You want to leave your heirs a tax-free inheritance.

Heirs will not pay tax on distributions from an inherited Roth account.

When Might a Roth Conversion Not be Advisable?

You expect your tax bracket to be lower when you are required to take distributions.

Generally, the goal is to minimize lifetime tax paid. If you convert to a Roth account, you’ll end up paying more tax now than if you keep your current account and wait to take the required distributions.

You want to make qualified charitable distributions (“QCDs”).

Once you are a certain age (currently 70.5), distributions from you IRA to qualified charities are tax-free, and they may satisfy all or a portion of your RMD.

Key Features of a Roth Conversion

• There are no income limitations to convert a traditional IRA or 401(k) to a Roth IRA.

• Before withdrawal, a Roth IRA must be held for 5 tax years, and the account-holder must be age 59.5, or earnings will be taxed and a penalty may be assessed. Limited exceptions apply.

• If tax rates are constant, the final account value of a Roth vs. net proceeds from a traditional IRA will be the same, regardless of time period or rate of return.

What You Should Know Before a Roth Conversion

• There is a possible impact on Medicare costs. Premiums for Medicare Parts B & D (medical & prescription drug insurance) are based on income, with a 2-year look-back period. A possible consequence of a Roth conversion is a boost in reportable income, and a temporary increase in Medicare premiums. However, the impact of a one-time Roth conversion will be short-lived as it will eventually fall off the 2-year radar.

While a bad period in the market may be an opportune time to convert (lower balance means less tax paid), depending on your income and availability of tax loss carryforwards, a more tax-efficient strategy may be tax loss harvesting.