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.