As fall ends and winter begins, many people wonder what end of the year financial tasks and tax planning strategies they should be thinking about.
One planning opportunity we review for clients is a Roth IRA conversion.
A Roth IRA conversion takes all or part of your existing balance in a traditional IRA and moves it into a Roth IRA. The money in a traditional IRA hasn’t been taxed yet, so in converting you pay taxes on the money your investments earned and on any contributions you originally deducted on your taxes.
Why would anyone pay taxes early? There are a few good reasons:
- Providing you meet certain requirements, Roth IRA withdrawals are tax-free in retirement.
- Unlike Traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) once you reach age 72 or during your lifetime. So, your money continues to grow tax-free.
- Roth IRAs are some of the best types of accounts to pass on to beneficiaries. While your heirs will have to take RMDs, they won’t have to pay any federal income tax on the withdrawals. Given recent legislation changes, inheriting Roth assets is even more favorable.
A Roth conversion can be a great option for some and a costly mistake for others. Here are 4 important considerations to make before converting your traditional IRA into a Roth IRA.
- Do you expect your income to increase in the future?
A big appeal of Roth accounts is tax-free withdrawals in retirement. If you believe you will be in a higher tax bracket in the future, it may make sense to pay taxes now at a lower rate. It may also make sense if your income is temporarily lower (i.e. between jobs for an extended period, missed a bonus, etc.)
If offered by your employer’s plan, also consider making Roth 401(k) and after-tax 401(k) contributions, which you may be able to convert to a Roth IRA through a mega-backdoor conversion. Note: this can be tricky, so be sure to talk to a qualified professional for help.
On the other hand, if you expect your income to decrease in the future, a Roth conversion may not make sense for you. Instead, consider strategies to minimize your tax liability now, such as deductible traditional IRA and 401(k) contributions.
2. Do you have cash outside your retirement accounts to pay the taxes due upon conversion?
While it’s possible to use some of your IRA to pay the tax bill, it’s typically not advised. Money withdrawn from your IRA to pay conversion taxes is considered a distribution, which could push you into a higher tax bracket. It could also result in a 10 percent penalty.
Additionally, using retirement funds to pay tax erodes the value of a Roth conversion. There’s less money compounding and growing tax-free.
3. Will you need distributions from the Roth IRA within 5 years?
The money you convert into a Roth IRA must stay there for a 5-year holding period. If withdrawals are made before the 5 years are up, you could be looking at a 10 percent penalty and/or additional income taxes.
If you’re retiring soon and will need to take distributions from your Roth, a conversion may not make sense for you.
4. Will a conversion bump you into a higher tax bracket?
If you’re on the cusp of the next tax bracket, it’s possible to still do a Roth conversion by only converting a portion of your traditional IRA. Spreading the conversion across several years, as opposed to one, can lower your yearly tax obligation.
Other Considerations
As we write this, the stock market is down 15% for the year. When account values are temporarily lower, the tax cost to convert is also lower – you pay tax on a smaller portfolio balance. When the market rebounds, you then have a larger portion of your total portfolio in a tax-free account.
You may also have expiring tax carryforwards or credits to use that could provide additional incentives to do a Roth conversion.
Heads up: if you currently or will soon participate in income-based benefits like Medicare or Affordable Care Act subsidies, a Roth conversion could impact the amount you pay or receive.
Before making any moves, know that a conversion is permanent–you can’t revert the money back to a traditional IRA.
We’re Here to Help
Wondering if a Roth IRA conversion is right for you? The decision hinges on many personal and unique circumstances, so it’s best to speak with a financial professional first. Reach out, we’re here to help.
Uplevel Wealth is a fee-only, fiduciary wealth management firm serving clients in Portland, OR and virtually throughout the U.S.
