The tax benefits of a Roth IRA are clear—tax-free growth potential and tax-free withdrawals in retirement.1 If you have been shut out of contributing to a Roth because of the rules concerning income limits, a Roth conversion for eligible retirement accounts2 is another way to have a Roth account. But, does it make sense if you are in or near retirement? The answer: maybe. A Roth IRA, even via a conversion, has the potential to benefit your retirement and legacy planning. That’s why we believe everyone should at least investigate a Roth IRA.
While your situation is unique and should be discussed with a tax adviser, here are eight things to keep in mind when weighing the decision to convert.
1. Where you will live in retirement
Are you planning to move to another state after you retire? Even if you expect your federal tax rate to stay the same in the coming years, the difference between your current and future state's tax rates may matter. And some states partially or entirely exclude retirement income—such as distributions from a traditional IRA—from state income tax—so, a conversion from a traditional to Roth IRA may be less attractive if you live in or plan to live in one that does.
If your future state of residence has a higher state income tax rate than your current one, it might make sense to convert at least some of your eligible assets to a Roth IRA before you move. Similarly, if you're moving from a state with a higher tax rate to one with a lower rate—or no income tax—you may want to avoid a conversion, or at least consider waiting to convert until the year after you've established your new residency.
2. Minimum required distributions (MRDs)
Roth IRAs do not require minimum distributions, but traditional IRAs and, generally, 401(k)s, 403(b)s, and other employer-sponsored retirement savings plans do, starting at age 70½. If you don’t need them for income, minimum distributions (also known as RMDs or MRDs) may feel like a nuisance. They need to be calculated each year, may provide unnecessary taxable income, and, if you miss taking one, can result in penalties. Also, you’ll likely reinvest the money in a taxable account—potentially reducing your after-tax return compared with what you’d receive if the money remained in a tax-advantaged IRA (traditional or Roth). A conversion of some or all other eligible amounts to a Roth IRA will reduce or eliminate your need to take MRDs and may also allow you to pass more of your retirement accounts onto your heirs (see No 4).
Consider this hypothetical example: Mark, 75, had $100,000 in a traditional IRA at the end of 2013. His wife, Ann, the sole beneficiary of his IRA, is six years younger. His required minimum distribution for 2014 would be $4,367.3 If he didn’t need this money for essential expenses, a Roth conversion of the assets remaining in the account after this year’s MRD could allow him to avoid successively larger MRDs in the years ahead, and provide an opportunity for his money to grow tax free instead.
3. The 3.8% Medicare surtax
Beginning in 2013, married couples (filing jointly) with a modified adjusted gross income (MAGI) of more than $250,000 are subject to a new 3.8% Medicare surtax. (The MAGI thresholds are $125,000 for married taxpayers filing separately and $200,000 for single filers.) The surtax applies to income from interest, dividends, capital gains, annuities, rents, and royalties; or MAGI in excess of the income thresholds, whichever is less. Your conversion amounts, like all taxable distributions from qualified accounts, are treated as income, and are therefore part of your MAGI, so they may cause your MAGI to be above these thresholds. That may cause you to incur the additional tax on your investment income.
But, after the conversion, the shoe is on the other foot. Since nontaxable withdrawals from a Roth IRA aren’t part of your MAGI, a Roth IRA conversion may potentially enable you to limit your exposure to the surtax down the road.
4. Leaving money to others
If you’re planning to leave your retirement savings to your heirs, consider how it may affect their taxes. Inherited traditional IRAs generate taxable income for heirs, often during their peak earning years, because of their minimum required distributions. These distributions could force them to incur taxes when they’d rather avoid them, or unintentionally push them into a higher tax bracket. So, inheriting Roth assets, which generally doesn’t generate any taxes, can be a benefit to your heirs. In addition, because you pay up front for the income taxes that are due, a Roth IRA conversion may also help reduce the size of your taxable estate.
On the other hand, if your heirs are likely to be in a much lower tax bracket than you are, it may be advantageous to leave them a traditional IRA—it may be better for them to pay lower taxes in the future than for you to pay higher taxes now.
Also, Roth IRA conversions may be disadvantageous to those who intend to leave at least some of their assets to charitable institutions, because traditional IRAs can typically be left to charity without any tax bill at all, for either party. So, in that case conversion will mean that the tax was paid needlessly. Thus, if leaving money to others is part of your plan, no matter what your goals, be sure to consult with an estate planning attorney and think carefully about your intentions before taking any action.
5. Gains on company stock in a workplace retirement plan
If you’re retiring and have appreciated company stock in your 401(k) or other qualified workplace savings plan, it may not make sense to convert these assets to a Roth IRA. Special tax rules on net unrealized appreciation (NUA), if you qualify, allow you to take a lump-sum distribution from your plan, pay income tax (and a 10% penalty, if you’re under 59½) on your cost basis, but defer taxes on the NUA—that is, the appreciation of the stock since you bought it—until you sell the stock. At that time, the NUA would be taxable as long-term capital gains. This will probably cost you less than having it taxed as ordinary income, as it would be in a Roth IRA conversion.
Here’s a hypothetical example to help illustrate the point. Tom, 60, has $100,000 of company stock in his 401(k). His cost basis is $10,000, meaning $90,000 is NUA and taxable as a long-term capital gain. His marginal income tax rate is 25%. Does it make sense for him to convert these assets to a Roth IRA?
As the hypothetical example above illustrates, in this situation it may be better to withdraw the company stock from the plan—allowing for capital gains treatment of the NUA—rather than converting it to a Roth IRA. (Note: If Tom were under age 59½, he might be subject to a tax penalty on the withdrawal of the cost basis, which in some cases can significantly change things.)
A Roth conversion option may still make sense if the NUA is a small percentage of the stock's market value or if your investment time horizon is sufficiently long, because of the potential for tax-free growth in a Roth IRA.
The IRS strictly enforces the NUA tax rules and other requirements that may apply to your situation. For instance, the tax advantage of the NUA rules could be reduced or possibly wiped out if your stock loses value before you sell it, or if you are in a lower federal income tax bracket when you sell. You should speak to a tax professional before pursuing an NUA strategy.
6. College-age children
If you have children attending or nearly attending college and who are applying for financial aid, a Roth IRA conversion may have an impact. Because the amount converted is treated as income, it’s included in the needs test on the Free Application for Federal Student Aid (FAFSA) and can potentially raise a parent’s expected financial contribution (EFC) and reduce aid. If you request it, some universities may adjust their calculation to account for Roth IRA conversion income, but federal aid formulas do not. So if you’re seeking financial aid, it may make sense to wait to convert until your children are out of college.
7. How you would pay for the conversion
It generally makes sense to use taxable assets rather than proceeds from a converted account to pay the tax costs of a Roth IRA conversion. This is because the rate of return after tax is generally higher inside a Roth IRA than outside of one, and it usually makes sense to pay for conversion with the assets that will earn a lower return. This is particularly true for those under age 59½, because for them using proceeds could also result in a 10% tax penalty and further reduce the potential benefit of converting.
Consider this hypothetical example: Elaine is 62 and has $100,000 in a traditional IRA and $25,000 in a brokerage account. Her current tax rate is 25% and she expects it to remain there. What would she have after five years if she converts her traditional IRA to a Roth IRA and uses proceeds to pay the taxes? How would that compare with using her brokerage account to pay for the conversion instead? (To keep it simple, the example assumes investment returns of 5% compounded annually in the Roth IRA, 4% compounded annually in the brokerage account after accounting for taxes, and does not take state taxes and other tax considerations into account.)
In both cases, Elaine uses $25,000 to pay the tax liability on the conversion, but if she uses assets from her brokerage account she could wind up with nearly $1,500 more after five years. That’s because returns on assets in the brokerage account are reduced by taxes (for example, taxes on dividend and interest distributions), while returns on assets in her converted IRA are not—they earn the pretax rate of return. So, using the brokerage account to pay for conversion results in all her remaining assets earning the higher, pretax rate of return, but using proceeds from the IRA means that some of her remaining assets earn the lower, post-tax rate of return. If Elaine could use money from a bank account rather than from a brokerage account to pay for the conversion, that would tend to make the benefit even larger, because bank accounts typically offer lower rates of return than brokerage accounts. If Elaine’s investment horizon were longer than five years, that too would increase the benefit of using assets other than proceeds from the IRA to pay for conversion.
8. You can undo one
Once you’ve converted, you have a limited opportunity to change your mind and undo a Roth IRA conversion through a recharacterization. You may decide the amount converted isn’t right for you or that your tax rates have been impacted affected by where you decide to live when you are retired. You may also find that if your account balance has fallen since the conversion because of a decline in the markets, it may make sense to recharacterize and then reconvert the lower balance (when eligible) and reduce the cost of your conversion. The deadline for completing a recharacterization is the last date, including extensions, to file or re-file refile your previous year’s taxes, which is typically on or about October 15. You can generally recharacterize all or a portion of the amount you converted.
No matter what age you are, if you are eligible convert a traditional IRA or 401(k) to a Roth IRA, it may benefit your retirement planning. If nothing else, it makes sense to take the time to confirm that you won’t benefit from a Roth IRA conversion. If you are not eligible—for example, if you’re still working and unable to take a rollover from your workplace plan—there may be another option for you to consider: an in-plan conversion to a Roth 401(k). Not all employers offer this, and even when they do, a Roth 401(k) lacks a few of the features of a Roth IRA—for example, conversion to a Roth 401(k) cannot be recharacterized, as discussed in No. 8, above; and, unlike Roth IRAs, Roth 401(k)s are subject to MRDs. But, if you are unable to convert to a Roth IRA, the Roth 401(k) option may be worth exploring. The key is to discuss your situation with a tax and financial adviser to help you fully assess the decision.
- Determine whether converting to a Roth IRA may make sense for you with our Roth Conversion Evaluator
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