Is a Roth conversion right for me?

When markets are lower, so are the taxes on a Roth IRA conversion. This may make a conversion seem tempting. However, there are a few questions that you should discuss with your wealth advisor and tax professionals before deciding if a Roth conversion is right for you.

What are some differences between a traditional IRA and a Roth IRA?

One critical difference between Roth and traditional IRAs is the timing of income tax. Contributions to traditional IRAs generally lower your taxable income in the year you contribute. As a result, withdrawals are taxed at your ordinary income tax rate.

In contrast, contributions to Roth IRAs are made with after-tax dollars and are not tax-deductible. However, since you paid the tax bill upfront, you do not pay any taxes on the withdrawals. In addition, you can withdraw contributions you made to a Roth IRA at any time and are not required to make Required Minimum Distributions (RMD).

Another advantage is that, if you pass away, some beneficiaries of your Roth IRA, specifically your spouse, minor children, individuals who are disabled or chronically ill, or someone no more than ten years younger than you, are not required to take distributions from the account, allowing the account to continue to grow on a tax-free basis.

Who can contribute to a Roth retirement account?

Eligibility to contribute to a Roth account is based on income. There are no income limits to make contributions to a traditional IRA or 401(k), but to make contributions to a Roth account, a single taxpayer's income cannot exceed $140,000, while a married couple filing jointly cannot have income higher than $208,000.

How can a higher-income earner contribute to a Roth IRA?

While higher-income earners cannot contribute directly to a Roth IRA, they can contribute indirectly through a backdoor Roth IRA strategy. To complete a backdoor Roth, you contribute to a traditional IRA and convert that amount to a Roth IRA. This strategy takes advantage of the fact that the IRS does not have any eligibility criteria for Roth conversions. Additionally, the IRS does not limit the amount of money an individual can convert.

Are there eligibility requirements to complete a Roth conversion?

Despite income limitations on who can contribute directly to a Roth account, every taxpayer is able to convert their traditional retirement account to a Roth account by completing a Roth conversion, which simply involves paying the tax on the traditional retirement account.

Are there possible tax implications of this transaction?

The amount you convert from a traditional IRA to a Roth IRA is treated as ordinary income in the year you complete the conversion. For example, assume a married couple files jointly, earns a combined $85,000, and each has a traditional IRA with $15,000. If they converted 100% of each IRA, their taxable income would increase from $85,000 to $115,000, raising their total tax bill by 66.4%¹.

Do I have to convert the entire balance in my traditional IRA?

No, a Roth conversion does not have to be all or nothing. A little bit of planning can go a long way in smoothing out the tax consequences of conversion. Using the example from above, if each spouse instead converts only 25% of their IRA, their taxable income will increase from $85,000 to $92,500, which would raise their total tax bill by only 16.6%². If they were to do this each year for the next four years, they will have converted both of their IRAs entirely and paid a lot less tax than if they converted all the funds in one year.

How can I cover the tax bill for a Roth conversion?

Since the converted amount is taxed as ordinary income in the year the conversion takes place, how you will cover the taxes is an important consideration. To get the most out of a Roth conversion, you may want to consider paying the tax bill using assets outside of the IRA in order to avoid depleting the amount of money that can benefit from tax-free growth.

How can I continue to plan for my retirement after conversion?

After making a Roth conversion, there are a couple of things you may want to keep in mind. First, the amount you convert does not count against your annual IRA contribution limit. For example, a 32-year-old with $45,000 in a traditional IRA who has not contributed to the account in the year they choose to convert could increase the balance of their Roth IRA by $51,000.

The second is to treat the balance in your Roth IRA as “funds of last resort” to maximize the benefits of tax-free growth. For example, a 26-year-old earning a 7% annual return on their $25,000 Roth IRA will have $688,248 by age 75 if they leave it alone. But if they were to withdraw just $10,000 at age 32, they would only end up with $504,805.

Is a Roth conversion right for me?

Despite the potential benefits, Roth conversions are irreversible and not beneficial for everyone. For example, a Roth conversion might make sense if you believe you will be in a higher tax bracket during retirement and need to lower your future taxable income. However, if you expect to be in a lower tax bracket during retirement, it may not make sense to convert to a Roth account and pay taxes now while in a higher tax bracket.

If you are considering a Roth conversion or have any questions, please consult your CPA, tax counsel or wealth advisor for help.

¹ Tax on $85K: ($20,550*10%) + ($62,999*12%) + ($1,451*22%) = $9,934   Tax on $115K: ($20,550*10%) + ($62,999*12%) + ($31,451*22%) = $16,534
² Tax on $85K: ($20,550*10%) + ($62,999*12%) + ($1,451*22%) = $9,934   Tax on $92K: ($20,550*10%) + ($62,999*12%) + ($8,949*22%) = $11,583  Percentage Change: ($11,583-$9,934) / $9,934 = 16.6%

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