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Why You Need to Consider a Roth IRA Conversion

Michael Atias, Director OTA Tax Pros
Michael Atias
Director of Tax Services, Instructor

What is a Roth IRA Conversion?

An IRA conversion, also known as a rollover, generally refers to the act of transferring assets held in a traditional IRA, or a similar retirement account, to a Roth IRA. Most investors can convert their IRA to a Roth even if they earn too much money to contribute to a Roth IRA directly.

What plans can you convert?

The types of IRAs you can rollover to a Roth IRA are:

  • Schedule a Free Tax ConsultationTraditional IRA
  • Rollover IRA
  • SEP-IRA
  • Simple IRA
  • SARSEP IRA
  • 401K or 403(b) from a former employer
  • 457(b)

What are the benefits of converting to a Roth?

While Traditional IRA accounts require you to start withdrawing minimum amounts once you turn 70 ½, there are no required minimum distributions (RMD) for a Roth account. These amounts are set by the IRS and failure to withdraw the RMD will lead to penalties. The fact that no RMD apply to a Roth account allows you to better control the amount of distributions you want to take and not be forced to do so by the IRS.

Also, if you don’t need to tap your IRA funds during your lifetime, converting to a Roth allows your savings to grow undiminished by RMDs, potentially leaving more for your heirs—who will also benefit from tax-free withdrawals during their lifetimes.

Another benefit that could be applicable to you is that converting to a Roth IRA early, while you are in a lower tax bracket, can help you put more money in your pocket later when you retire. This can also be beneficial if you feel that the government will be raising taxes over the course of your lifetime. Keep in mind that although the new tax reform reduced the tax rates for most Americans, these tax reductions are not permanent and are set to expire after 2025. It is quite possible, and plausible, that future tax rates will be higher than the current ones.

pros and cons of converting to a Roth IRA

What are the drawbacks of a Roth IRA conversion?

The biggest drawback you need to consider is that a Roth conversion is a taxable event, which means that any assets you convert to a Roth account will be included in your gross income. The tax bill on a conversion can be a massive one.

For example, let’s look at a married couple with $150,000 in taxable income. Say they want to convert $100,000 to a Roth account. Currently, their federal tax bracket is 24%, however, if they convert the entire $100,000 in one calendar year they will jump a tax bracket to 32%. Furthermore, they could possibly lose certain tax credits based on income such as the American Opportunity Tax Credit (Education Credit). This could lead to this couple paying up to $10,000 in additional taxes.

The decision to convert to a Roth IRA doesn’t have to be all or nothing, though. You may find dividing your savings among a Roth and traditional IRA and/or a Roth and traditional 401(k) is the optimal solution.

In the above example, they could choose to do the conversion over three calendar years. By converting a third today, the second third on January 2nd, and the final third on January 2nd of the following year, they avoid being pushed into a higher tax bracket. It would only have taken them approximately 15 months to convert the entire $100,000, and they saved thousands in tax liability.

Aside from the tax implications, another potential drawback is that if you are younger than 59 ½ you will need to keep the money in a Roth for 5 years before taking any distributions from the Roth. Any distribution earlier than the 5-year period will impose a 10% early withdrawal penalty. There are exceptions to this rule, so again, consult a tax advisor.

There could be many different scenarios and many different considerations. If you really want to find the ideal solution for you, then we recommend that you consult with an experienced tax advisor.

How do you convert to a Roth IRA?

If you do decide a Roth IRA conversion is right for you, you’ll need to determine two things:

  1. When to execute the conversion: You may want to carry out multiple Roth IRA conversions over several years. If done properly, a multiyear approach could allow you to convert a large portion of your savings to a Roth while limiting the tax impact. Early in retirement—when your earned income drops but before RMDs kick in—can be an especially good time to implement this strategy.
  2. How you’ll pay the resulting tax bill: Ideally, you’d have cash on hand outside your IRA to pay the income tax on any converted funds. The main reason is that any IRA money used to pay taxes won’t be accumulating gains tax-free for retirement, undermining the very purpose of a Roth IRA conversion. There are other tax effective ways to pay the tax bill on the conversion that require further analysis by a tax advisor.

Converting to a Roth IRA is a powerful tool that can give you the potential to cut your tax bill in retirement but be sure to consult a qualified tax advisor before making the move.

Disclaimer
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