A Roth IRA conversion is essentially the transferring of money from a Traditional IRA to a Roth IRA. Since this blog topic is a bit more complicated than usual, we will start with some basics.

A traditional IRA is what most of us think about when we put away money for our retirement. Like a 401k, with rare exception, the money in a Traditional IRA has never been taxed. The contributions to an IRA or 401k are deductible from your income in the year they were made and thus, tax-deferred. In addition, all dividends, interest, and capital gains are not taxed until the funds are distributed from the IRA in retirement. This allows for very powerful growth of a traditional IRA without the drag of taxes. However, it can create problems in retirement if you happen to be in a higher tax bracket than expected and if you reach the age of 70 ½ and need to start taking Required Minimum Distributions*. These distributions, that you no longer have control over, can push you into a much higher bracket than expected and create a tremendous tax liability.

*A Required Minimum Distribution (RMD) is a term used for the requirement by the IRS that you take a certain amount of your money out of an IRA or 401k by April 1st of the year following the year you turn 70 ½ and each year after. This amount increases as you age based on your life expectancy. If you have a pre-tax traditional IRA, you cannot escape RMD’s.

A Roth IRA actually has the opposite tax structure. All contributions made to a Roth are on an after-tax basis (there is no deduction allowed in the year of your contribution), however, all of the growth and distributions on those deposits (if held for at least 5 years and your age is over 59 ½) is tax-free. That’s right, not a dime of tax is paid if that money is used in retirement. If you save $10,000 in a Roth in your 20’s and it grows to $50,000 in your 60’s, the $40,000 of growth is NEVER taxed. In addition, you are not responsible to make Required Minimum Distributions once you turn 70 ½. This makes a Roth a tremendous vehicle for legacy planning or tax rate management later in life.

The IRS also allows you to “convert” as much of your Traditional IRA to a Roth IRA as you’d like at any time. There is only one catch when you convert, you will pay ordinary income tax on 100% of the money you convert in that year. Essentially, if you convert $100,000 in 2019 from a Traditional IRA to a Roth IRA, you can add $100,000 right on top of your income for 2019, potentially pushing you into a higher tax bracket. Boy…that is quite a catch!

Despite the obviously negative side effects to a Roth conversion, there are times when a conversion makes sense:

• Any time your current income tax rate is anticipated to be lower than the years you are expected to take IRA distributions. Ex.
  • You lose a job or have a low-income year and expect to be in a very low tax bracket due to your reduced income
  • A year where tax rates are historically low (like 2018 and 2019) due to Federal tax cuts. Currently, you can earn (or convert) a lot of money and still remain in the 24% tax bracket or lower.
• An attempt to reduce future Required Minimum Distributions due to a high liability in future years. Those who have large pre-tax IRA’s will be taking large distributions that they most likely will not need in their 80’s and 90’s if nothing is done about it today. Converting to a Roth IRA can reduce that future liability.
• If you have a lot of time until retirement and compounding will be a very powerful friend in a Roth. This can be a valuable strategy if you are young with a smaller Roth IRA, especially when coupled with a low current tax bracket.

Obviously, this is not much more than a primer to help you decide if you should start considering a Roth conversion. This decision is a complex one that includes many variables. Increasing your income in any year can affect Medicare premiums, dividend and capital gains tax rates, and create a whole host of other potential unintended consequences. It is always recommended that you sit with your accountant and/or a good fee-only planner to help you think through the pros and cons of this strategy. However, for those that do fall into one of the situations above, it can be a powerful tool that can change the financial scope of your retirement. That is worth at least exploring.