Considerations When Converting to a Roth IRA

August 28, 2020 | Article

By Melissa White

Anyone with a traditional Individual Retirement Account (IRA) that has a reasonably high balance should—after considering the current (and potentially higher) future federal income tax rates, the economic environment, and recent passage of the SECURE Act and CARES Act—assess the benefits of converting their traditional IRA to a Roth IRA.

Converting an existing traditional IRA, or other qualified retirement account, to a Roth IRA can make sense in many different situations, but not all. There is no bright line rule or optimum conversion amount for all individuals.

While tax considerations are important, the benefit of the conversion strategy depends on your unique situation: your income, your tax bracket, the financial goals you wish to accomplish and your wealth transition goals. It can make sense to pay the tax now to avoid more tax in the future, but there are many personal situations where a Roth IRA conversion may not be the best solution.

The following is provided to help you evaluate some of the pros and cons of a Roth IRA conversion. But, as you read further, remember: all items mentioned need to be considered in making your conversion decision. That decision usually will not turn on only one item.

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When Should You Consider a Roth IRA Conversion?
There are several things to assess when contemplating converting your traditional IRA to a Roth IRA. We’ve outlined a few key considerations when making this decision.

  • When you will likely be in a higher tax bracket in the future.A distribution from a Roth IRA is not taxable. Converting to a Roth IRA and paying taxes on the converted funds now, while you’re in a lower tax bracket, will allow you to avoid having to pay income taxes at a higher tax rate once you reach retirement and begin taking distributions from your traditional IRA. State taxes will also need to be considered, especially if you are considering a move to a state tax jurisdiction with higher rates.
  • When you have losses that can offset tax liability from the conversion.Converting to a Roth IRA will require you to pay income taxes on the converted amounts in the year of conversion, which will need to be paid, for the best results, from nonretirement funds or assets. With that in mind, particularly if funds are not readily available to pay the tax due, it can make sense to do a Roth IRA conversion in a year when you have specific currently deductible losses that can be used to offset the tax liability from the conversion.
  • When you don’t want to begin taking distributions at age 72.For most retirement accounts, due to changes made in recent legislation, required minimum distributions (RMDs) will begin at age 72. Roth IRAs have no RMDs at any age while the owner of the account is living. This allows the funds in your account to stay invested longer to better leverage the power of investment growth at a level greater than if distributions are required.
  • When you want to leave a tax-free inheritance to your heirs.With passage of the SECURE Act, beginning in 2020, an IRA owner and a surviving spouse still have the ability to take distributions from an IRA over their life expectancies, but non-spousal beneficiaries of traditional IRA accounts, such as children and grandchildren, will generally have a 10-year distribution requirement. However, the new 10-year distribution requirement allows some planning opportunities since there is no annual amount required to be distributed, which could allow for the total distribution to wait for year 10 if so desired.

When Would You Not Want to Consider a Roth IRA Conversion?

  • When you or your beneficiaries will be in a lower tax bracket than your current rate.If you have reason to believe you’ll be in a much lower income tax bracket in retirement or you anticipate your beneficiaries will be in a lower tax bracket when they take distributions, then a Roth IRA conversion may not leave you better off. By not converting to a Roth IRA, you can avoid paying any additional taxes generated by the conversion now at a higher rate, and instead pay income taxes on your distributions at a lower rate in the future as taken.
  • When you don’t have nonretirement cash or assets to pay the tax on the conversion.The benefits of a conversion would be lessened if you need to take a taxable retirement distribution or obtain a loan to pay the additional income tax generated by the conversion.
  • When you may need the money sooner rather than later.Withdrawal of money that was moved to a Roth IRA via conversion is subject to a five-year holding period. This means, if you think you’ll need the money back before five years, factor that into your Roth conversion decision since you would have to pay a penalty if you take distributions within a five-year period after the conversion.
  • When you have significant charitable intent.IRA owners age 70 ½ can have up to $100,000 per year distributed from a qualified IRA directly to qualified public charities using qualified charitable distributions (QCDs). While there is no charitable deduction permitted for the QCDs, the amount does not have to be claimed as income. However, the entire distribution must meet the rules for deductibility of a charitable contribution, disregarding the percentage limitation, if it were to have been available for deduction on the personal tax return of the IRA owner making the QCD. And, if you are designating charitable beneficiaries for your retirement account, the benefits of a Roth IRA would be limited.

Cautionary Considerations
Substantial financial benefits can be gained when a Roth IRA conversion is implemented in the right circumstances. However, you should discuss the ramifications of this decision with your tax advisor beforehand. They can model it out to determine the various potential benefits and costs. Especially since Roth IRA conversions are irrevocable and can’t be changed back. Therefore, proceed with caution and become informed before committing to the conversion.

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