Is a Roth Conversion Right for You?
Retirement planning discussions often include Roth conversions, which involve moving funds from a pre-tax retirement account, such as a Traditional IRA, into a Roth IRA. Unlike traditional retirement accounts, Roth IRAs are funded with after-tax dollars, allowing for tax-free growth and tax-free qualified withdrawals after age 59½. One of the primary benefits of a Roth conversion is reducing future required minimum distributions (RMDs), since Roth IRAs are not subject to RMDs during the original owner’s lifetime.
While that strategy can create long-term tax advantages, a Roth conversion is not automatically the right move for everyone. The potential benefits depend heavily on your income, tax bracket, retirement timeline, and overall financial picture.
Timing and Tax Brackets Matter in Roth Conversion Planning
Roth conversions are often a useful tool for investors who expect to land in a higher tax bracket after retirement. Conversely, those who may have some low-income years may also want to take advantage of a conversion.
Taxes are due on the amount converted at the time of conversion. The transaction is treated as a withdrawal and is taxed as ordinary income. The goal is typically to pay lower taxes now. As a result, most people only convert enough at a time to stay in their same, current tax bracket.
Additionally, instead of having withholding taken out of the distribution to cover those taxes, it is encouraged to pay those taxes with other funds, so you receive the full amount deposited into the tax-deferred account.
Roth Conversions Can Play a Role in Estate Planning
People also choose to do a Roth conversion for estate planning purposes. Some investors don’t need retirement funds to live on in their later years. Instead, they want their retirement accounts to pass on to their heirs. If that’s you, moving your funds into a Roth account could help reduce the tax burden for those heirs.
Withdrawals from an inherited Roth IRA are tax-free. Also, there are no Required Minimum Distributions (RMDs) from a Roth account, so money can continue to grow tax-free until the heir chooses to withdraw the money.
When a Roth Conversion May Make the Most Sense
As already mentioned, the best time to do a Roth conversion is when you are in a lower-income situation than you will be when you reach the age for RMDs. Some say that “trough years”, the period when you have retired but have not yet reached RMD age, is the best time to do so. The assumption is that your income is lower in those years, and the tax effect would also be lower. It is also recommended that conversions take place over multiple years rather than in a single lump sum, which helps reduce the tax burden on the conversion.
Potential Drawbacks and Considerations
As with any investment vehicle, there are a few potential downsides to a Roth conversion to consider when making the right decision for you:
- Once the conversion takes place, it is irrevocable.
- If not planned properly, the amount converted can push you into a higher tax bracket.
- The conversion can trigger higher Medicare premiums (Income-Related Monthly Adjustment Amount, IRMAA)
- There is a five-year holding period after the conversion takes place and before a withdrawal can be made.
Roth Conversion Decisions Should Be Part of a Bigger Tax Strategy
The decision to convert to a Roth IRA requires careful planning. It is important to look at what your anticipated annual income will be in your RMD years to determine if you will truly be in a higher tax bracket during that time in your life. If you will not be, or you do not have enough information to make that determination, then it may not make sense to make that move.
If you would rather pay the tax on those funds and not pass on a tax burden to your heirs, then that approach may outweigh any of the reasons not to do so. Regardless of your reasons for wanting to pursue a Roth conversion, it is important to meet with your tax advisor to discuss the various implications of doing one.
At Leone, McDonnell & Roberts, we are always happy to have that discussion with our clients. Schedule a consultation today to learn more.
