Mar 22, 2023
Tax-Smart Strategies: Why Consider a Roth IRA Conversion Now?
Converting all or part of your pre-tax retirement account to a Roth IRA can be a big decision with potentially significant tax consequences. In this part of our series on tax-smart strategies, we will look at why—and when—it might make sense for you.
A Roth IRA conversion involves the transfer of assets from a traditional IRA, a simplified employee pension (SEP), a SIMPLE IRA or a defined-contribution plan, such as a 401(k), into a Roth IRA. While you will have to pay income tax on the money you transfer, any future growth of those assets within the Roth IRA will be tax-free, as will any future withdrawals assuming the five-year rule is complied with.1
In our view, the main reason to consider converting your plan is because you would prefer to pay tax now rather than later. From a timing perspective, you might find that the advantages are more compelling while you are in a certain tax bracket, by a particular age or life milestone, before an expected tax rule change or as a result of recent market activity.
Why might now be the right time to consider a Roth IRA conversion? Here are a few factors that you might wish to discuss with your wealth advisor.
Roth IRA conversion to take advantage of market timing
The MSCI ACWI Index is designed to represent performance of the full opportunity set of large- and mid-cap stocks across 23 developed and 24 emerging markets.2 An exchange-traded fund that tracks this index (ticker ACWI) was down by 18.37% during 2022.3 We believe it is fair to suggest that many, if not most, equity investors lost money last year.
This could create interesting timing to convert traditional IRA assets to a Roth account for two reasons. The first reason is that, since the value of the underlying assets could be lower due to the market decline, the amount of taxes owed could be decreased. The second reason is that the future recovery in the value of your portfolio will be tax-free within the Roth IRA.
Roth IRA conversion to benefit from lower tax rates
The 2017 Tax Cuts and Jobs Act lowered income tax rates across the board. However, these lower rates will sunset after 2025, which will make Roth conversions more expensive.4 It could be beneficial to take advantage of the current lower rates while they are still around.
Roth IRA conversion to “prepay” estate and income tax
Depending on your situation, a Roth conversion may be beneficial to reduce estate taxes and effectively prepay income taxes for your heirs. Here’s how it works.
If you were to pass away while owning a traditional IRA, your estate could owe tax on the value of the account, and your heirs could owe tax on any withdrawals they made. Doing a Roth conversion means paying tax on the account value now so that neither your estate nor your heirs will owe any further income taxes.
When considering a Roth conversion for estate tax purposes, two variables to take into account are your current tax rate versus the anticipated tax rate of your heirs, plus the potential impact of state taxes.5 For example, if your heirs live in a state that taxes traditional IRA withdrawals, it might argue more strongly in favor of doing a conversion.
Other considerations before a Roth IRA conversion
The amount you convert to a Roth is treated as ordinary income. This is important because it could have the effect of pushing other types of income, such as qualified dividends and capital gains, into higher tax brackets.6 Also be aware that moving into a higher income bracket could have consequences for someone who is on Medicare.7 For both of these reasons, it is wise to consider all of the potential ripple effects before following through with a Roth IRA conversion.
Whether a Roth IRA conversion is right for you—and whether now is truly the best timing—depends on numerous individual factors. But if you see yourself in any of the scenarios presented here, it might be time to ask your wealth advisor for a professional opinion.
1 https://www.investopedia.com/ask/answers/05/waitingperiodroth.asp
2 https://www.msci.com/our-solutions/indexes/acwi
3 https://ycharts.com/companies/ACWI/performance
4 https://www.law.cornell.edu/wex/tax_cuts_and_jobs_act_of_2017_(tcja)
5 https://www.investopedia.com/articles/managing-wealth/090816/inherited-ira-distributions-and-taxes-getting-it-right.asp
6 https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras#Distributions%20(Withdrawals)
7 https://www.medicare.gov/Pubs/pdf/11579-medicare-costs.pdf
ABOUT THE AUTHOR
Matt Foltz, CPA, CFP, CEPA, MS in Accountancy
Matt sits on BDF's Financial Planning Committee and leads many of the firm's tax-related initiatives. He has a passion for building strong relationships with his clients and helping them make sound decisions. Matt also holds the Certified Exit Planning Advisor designation which helps him advise business owners on how to exit their business and prepare for retirement.
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