Prior to 2010, converting all or part of your IRA to a Roth IRA was only an option for those with adjusted gross income of $100,000 or less. Now, the IRS allows everyone to convert. Unfortunately, most people shy away from a Roth conversion due to the upfront tax that must be paid on the IRA funds that are converted. What they don’t realize is that paying taxes now can actually help save on taxes in the future.
Who Should Convert?
Most Roth conversion strategies involve tax bracket arbitrage, which in this situation means creating wealth by reporting income when you think your tax rate will be lower. Taking more income and paying more tax in the present allows you to take less income in the future, thereby saving you on taxes at that time. You will want to consider this strategy if you meet the following criteria:
- You are currently retired or are otherwise in a low income tax bracket. When you convert to a Roth IRA, the amount that you are converting from your 401(k) or IRA will be taxed 100% at ordinary income rates. Therefore, it is best for you to do a Roth conversion in years that you are in a low income tax bracket. (Note: If you retire young, you can still do a Roth conversion before age 59½ without suffering an additional 10% penalty tax, as the conversion is not considered a withdrawal. Just make sure the funds really do get converted, and that you aren’t using them for something else.)
- You are not yet 70½. Once you turn 70½, your retirement accounts [traditional IRAs, 403(b)s, 401(k)s, etc.] are subject to required minimum distributions (RMDs), which means you are forced to take a significant chunk out of your retirement accounts each year. This often forces retirees into a much higher tax bracket. Therefore, once you pass this age, it’s probably too late to start doing Roth conversions, unless your main goal is leaving tax-free income to your heirs.
- You have funds outside of your retirement accounts to pay for the additional taxes. If you don’t have excess cash outside of your retirement accounts to pay the tax due on the Roth conversion, you are not a good candidate for this strategy.
How to Convert
If you decide you could benefit from a full or partial Roth conversion in any given year, consider following this strategy:
- Convert only partially to maximize income in your current tax bracket. Your financial advisor and CPA can work with you to figure out the maximum amount you can convert without pushing you into the next marginal tax bracket. As income can vary from year to year, you should do this calculation on an annual basis.
- Pay any tax owed from your taxable accounts. Again, it is important that you don’t withdraw funds from your converted IRA to pay taxes on the conversion, as you will lose most of the benefit of the conversion if you do this. Make sure you have enough money in your bank account to pay the estimated tax on the conversion. Or even better, try to offset the tax against a carryover loss.
- Recharacterize if you made a mistake. If you accidentally convert too much or come into extra income so that the conversion no longer makes sense, never fear. You can undo your Roth conversion as long as you do it before October 15 of the next year. We usually suggest that the recharacterization is complete by the time you file your return.
- Do not withdraw earnings within five years of the conversion. Roth earnings are only qualified if withdrawn after five years of the conversion, so make sure you do not need the funds from your Roth before then. The Roth IRA should ideally be the last place you go to withdraw money.
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Reaping the Benefits
Individuals who convert their traditional retirement accounts to Roth IRAs will notice the following benefits in the future:
- The potential for lower taxes beginning at age 70½ due to a smaller RMD.
- The potential to avoid the 3.8% Medicare surtax on net investment income if RMDs are small enough.
- A higher net worth, as more money remains in retirement accounts to grow tax deferred.
- The ability to eventually leave a large, tax-free inheritance to your heirs, if you never touch the account. Imagine your grandchild being able to use the money you leave them to pay for education, buy their first home, or start a business without having to pay tax on those funds.
You should consult with your financial planner and CPA, who can both run detailed projections, to find out if doing a Roth conversion is right for you.