Understanding Roth Conversions: Why They Might Make Sense for You
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A Roth conversion is when you transfer funds from a traditional retirement account like an IRA or 401(k) into a Roth IRA. When you do this, you pay taxes on the amount you transfer since contributions to traditional accounts are made with pre-tax dollars. However, once the funds are in the Roth IRA, they grow tax-free, don’t have a Required Minimum Distribution, and qualified withdrawals aren’t subject to taxes.
A Roth IRA distribution is considered qualified and therefore tax-free if it meets two conditions. First, the account must have been open for at least five years. Second, the withdrawal must occur under certain circumstances, like being at least 59½ years old, disabled, or $10,000 for a first-time home purchase. If both conditions are met, the distribution is qualified and tax-free. Otherwise, earnings may be taxed and could face a 10% penalty.
Reasons to consider a Roth Conversion:
Tax Arbitrage - The most common explanation for considering a Roth conversion is simple tax arbitrage. If you’re in a lower tax bracket now than you expect to be in the future, a Roth conversion allows you to lock in today’s tax rates. This is especially relevant if you anticipate higher income in later years or if you expect tax rates to rise. Of course this requires some predictions and forecasting but is worth doing the math and looking at your future needs and expenses so you can make an educated decision.
RMDs - Once you reach age 73 (or 75 if you were born after 1960), you must start taking RMDs from most traditional retirement accounts. RMDs can push you into a higher tax bracket, increasing your tax burden. Some people saved very diligently into their retirement accounts and those accounts have grown beyond expectations. For many, those accounts can throw of an RMD that when combined with Social Security, is quite a bit higher than what they need in income during retirement. This results in a situation where they are essentially paying taxes on income that they don’t even need. By converting some of your traditional IRA funds into a Roth IRA, you may be able reduce the balance in your traditional accounts, lowering future RMDs and the associated tax impact.
In order to calculate if this makes sense for you, you’d need to look at your income needs in retirement as well as your account balances in both traditional and taxable accounts in order to forecast what your cashflow situation will look like. Here is a more thorough explanation of this scenario that I wrote a longer post about.
Tax Free Growth - One of the biggest benefits of a Roth IRA is that it allows for tax-free growth. Once your funds are in a Roth IRA, they can grow without being subject to annual taxes on interest, dividends, or capital gains. Also, when you look at the balance of your 401(k) or IRA, remember that a portion of that is the Governments… When you look at a Roth account, it’s all yours if you take qualified1 withdrawals.
Legacy/Estate Planning – If leaving a healthy estate for your heirs is important to you, a Roth conversion has some benefits. Beneficiaries of a Roth IRA can take distributions without paying income taxes on the growth, making it an efficient way to pass on wealth3.
A traditional IRA requires beneficiaries to withdraw the entire balance within 10 years and pay taxes on those withdrawals while a Roth IRA allows heirs to withdraw funds over the same period without worrying about tax consequences. This can be especially valuable for younger beneficiaries, who can let the account continue to grow tax-free for up to 10 years after inheriting it3.
In contrast, a taxable account receives a step-up in cost basis, reducing capital gains taxes upon inheritance, but any further growth is subject to taxes2. While this step-up can be advantageous, the Roth IRA's combination of tax-free growth and withdrawal flexibility often makes it the better choice for those looking to maximize what they leave behind.
What I like to do is run two scenarios side by side that compare the estate you’d leave behind with and without a Roth strategy. That way we can see if it increases the size of the estate, the tax efficiency, or both.
Reasons not to do a Roth Conversion:
While Roth conversions can be beneficial for many, they aren’t always the best fit for everyone. Here are some scenarios where it might not make sense:
High Tax Bracket Now, Lower in the Future: If you expect to be in a significantly lower tax bracket during retirement, converting now might result in a higher tax bill than necessary. This is especially true if you’re still in your peak earning years. Paying taxes now at a high rate could negate the potential long-term benefits of tax-free growth in a Roth IRA. It’s important to note however, that if you have a large retirement savings balance, RMDs might force your income up whether you need the money or not.
You Don’t Have Cash to Pay the Tax Bill: One of the main hurdles of a Roth conversion is that you’ll need to pay taxes on the converted amount. Ideally, you’d pay these taxes with funds outside of your retirement accounts to maximize the converted Roth balance. If that’s not possible and you have to dip into your IRA to cover the tax bill, the benefits of the conversion could be substantially reduced. Also, paying the taxes from inside the IRA prior to age 59.5 is consider a distribution and therefor is subject to an early withdrawal penalty5.
Potential Impact on Medicare Premiums and Other Benefits: A Roth conversion can increase your income in the year of the conversion, potentially pushing you into a higher Medicare income-related monthly adjustment amount (IRMAA) bracket. This could result in increased Medicare Part B and Part D premiums, along with a higher tax liability on Social Security benefits. If managing these costs is a priority, a conversion may not be the right move.
How Does a Roth Conversion Actually Work?
The process of a Roth conversion is relatively straightforward but requires some planning:
Determine the Amount to Convert - Decide how much of your traditional IRA or 401(k) you want to convert to a Roth IRA. This amount will be added to your taxable income for the year, so it’s essential to consider how it will impact your tax bracket.
Pay the Taxes - The converted amount is treated as ordinary income in the year of the conversion, and you’ll need to pay taxes on it. It’s usually best to pay these taxes from sources outside of your IRA to maximize the amount that remains in the Roth account4.
Complete the Conversion - Most financial institutions can help you transfer the funds from your traditional IRA to a Roth IRA. The process typically involves filling out some paperwork and specifying which accounts the funds will move between and whether or not to withhold taxes.
Wait for the 5-Year Rule - To withdraw converted funds tax-free, you must adhere to the 5-year rule. This means you need to wait at least five years after the conversion before taking out the converted amount without penalty if you’re under age 59½. However, growth on the converted amount remains subject to Roth IRA withdrawal rules1.
Is a Roth Conversion Right for You?
A Roth conversion can be a great strategy if you expect higher tax rates in the future, want to manage your RMDs, or plan to pass on tax-free assets to your heirs. However, the upfront tax cost means that you’ll want to carefully evaluate the numbers to ensure it makes sense for your situation.
When considering a Roth conversion, I like to run two scenarios side by side—one with a Roth conversion strategy and one without. These scenarios factor in various elements, including account balances, growth expectations, future savings rates, retirement income needs, and income sources like Social Security and pensions. By comparing the two, we can see the expected outcomes and understand the potential advantages of each approach. In some cases, both scenarios may result in a similar estate value, but if in retirement you are in a higher tax bracket than when you retire than you are now the Roth conversion may offer a tax savings. Other times, you may pay more in taxes or tax savings might be modest, yet the long-term tax benefit to your heirs could be substantial. And sometimes, there’s no clear benefit at all. The key is to run the numbers to determine whether a Roth conversion makes sense for your specific situation.
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1https://www.investopedia.com/roth-ira-withdrawal-rules-4769951
2https://www.investopedia.com/terms/s/stepupinbasis.asp
3https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
4https://www.investopedia.com/articles/financial-advisors/102715/pros-and-cons-creating-backdoor-roth-ira.asp
5https://www.irs.gov/taxtopics/tc557
A Roth Conversion may not be right for everyone. There are a number of factors taxpayers should consider before converting, including (but not limited to) whether or not the cost of paying taxes today outweighs the benefit of income tax-free Qualified Distributions in the future. Before converting, taxpayers should consult their tax and legal advisors based on their specific facts and circumstances.
Steward Partners, its affiliates, and Steward Partners Wealth Managers do not provide tax or legal advice. You should consult with your tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters.
Individuals are encouraged to consult their tax and legal advisors (a) before establishing or changing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account. Tax laws are complex and subject to change.
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