The tax benefits of a Roth IRA are clear: Tax-free growth potential and tax-free withdrawals in retirement.1 If you aren't able to contribute to a Roth IRA because of the income limits,2 a Roth conversion of eligible retirement accounts is another way to have a Roth account.3 But does it make sense if you are retired or within 15 years or so of retirement? Maybe. A Roth IRA, even via a conversion, has the potential to benefit your retirement and legacy planning.
While your situation is unique and should be discussed with a tax advisor, here are 7 things to keep in mind when thinking about a conversion.
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 if you live in, or plan to live in, a state that does, a conversion from a traditional IRA to a Roth IRA may be less attractive.
If your future state of residence has a higher state income tax rate than that of 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 you've established your new residency.
2. Required minimum distributions (RMDs)
Roth IRAs do not have required minimum distributions during the life of the original owner. But traditional IRAs and, generally, Roth and traditional 401(k)s, 403(b)s, and other employer-sponsored retirement savings plans do, starting at age 70½. If you don't need the income from these distributions to meet current retirement expenses, RMDs 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 stiff penalties. And if you reinvest your RMDs in a taxable account, you are potentially reducing your after-tax return compared with what you'd receive if the money remained in the tax-advantaged traditional or Roth IRA.
A conversion of some or all other eligible amounts to a Roth IRA will reduce or eliminate your need to take RMDs and may also allow you to pass more of your retirement account savings on to your heirs (see No. 4). It may be advantageous to convert before you turn age 70½, since you will otherwise be required to take RMDs before any conversions.
Consider this hypothetical example: Mark, 75, had $100,000 in a traditional IRA at the end of last year. His wife, Ann, the sole beneficiary of his IRA, is 6 years younger than he is. Mark's RMD for the year would be $4,367.4 If Mark didn't need this money, a Roth conversion of the assets remaining in the traditional IRA could allow him to avoid successively larger RMDs in the years ahead, and provide an opportunity for his money to grow tax-free instead. Of course, Mark would need to factor in the tax payment triggered from a conversion to see if this strategy makes sense for his situation (see No. 7).
3. The 3.8% Medicare surtax
Married couples (filing jointly) with a modified adjusted gross income (MAGI) of more than $250,000 may be subject to a 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 net investment income (which includes income from interest, dividends, capital gains, annuities, rents, and royalties, among other things); or MAGI in excess of the income thresholds, whichever is less.
The amount you convert from a traditional IRA to a Roth IRA is treated as income—just like all taxable distributions from pretax qualified accounts. Therefore the conversion amount is part of your MAGI, and it may move you above the surtax thresholds. This may cause you to incur the additional Medicare surtax on your investment income.
For more information on this, read Viewpoints on Fidelity.com: 6 key Medicare questions
But, once your money is in a Roth IRA, the shoe is on the other foot. Because 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 Medicare surtax down the road.
4. Leaving money to others
If you're planning to leave retirement savings to heirs, consider how it may affect their taxes. Because of their RMDs, inherited traditional IRAs generate taxable income for heirs, often during their peak earning years. These distributions could incur taxes when they'd rather avoid them, or unintentionally push them into a higher tax bracket. Inheriting Roth IRA assets, which generally don't incur any income taxes, can be a benefit to your heirs. In addition, the income taxes paid on a Roth IRA conversion may also help reduce the size of a taxable estate.
But there are many details to consider. For example, 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. That's because 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. 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.5
If leaving money to others is part of your plan, no matter what your goals are, be sure to consult an estate planning attorney and think carefully before taking any action.
Read Viewpoints on Fidelity.com: An all-in-one wealth transfer checklist
5. Workplace retirement plan options
There are 2 different workplace retirement programs to consider when planning the timing and size of a Roth conversion: company stock options and the Roth 401(k) option.
If you're retiring and have appreciated company stock in your traditional 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, and pay income tax (and a 10% penalty, if you're under age 59½) on your cost basis. You can then 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.
Read Viewpoints on Fidelity.com: Make the most of company stock
Roth 401(k) option
If you're still working, you are not typically allowed to do a Roth IRA rollover from your 401(k) or 403(b). However, you may consider 2 options: Contribute to your company’s Roth 401(k) if offered by your employer, or do an in-plan conversion to a Roth 401(k). Not all employers offer in-plan conversions, and, even when they do, a Roth 401(k) lacks a few of the features of a Roth IRA. Unlike Roth IRAs, Roth 401(k)s are subject to RMDs. But, if you are unable to convert to a Roth IRA, the Roth 401(k) option may be worth exploring. This is especially true for those who have made after-tax contributions (also called nonqualified contributions) to their 401(k) plan. The key is to discuss your situation with a tax and financial advisor to help you fully assess the decision.
6. College-age children
If you have children who are currently in—or are close to starting—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 in their private financial aid formulas, but federal aid formulas do not. So if you're seeking financial aid, especially federal, it may make sense to wait to convert until your children are out of college.
Read Viewpoints on Fidelity.com: 3 "must-know" college financial aid tips
7. How you would pay for the conversion
A Roth IRA conversion has a cost, which is the income taxes on the amount you convert. It generally makes sense to use taxable assets rather than proceeds from a converted account to pay the tax cost of a Roth IRA conversion. This is because, all things being equal, the rate of return is generally higher for a Roth IRA because no taxes are due for any gains in a Roth IRA—and taxes reduce the returns you achieve. Consequently, it usually makes sense to pay for a conversion with the assets that will earn a lower after-tax return (taxable assets already outside of the Roth IRA). This is particularly true for those under age 59½, because, for them, paying for a conversion using proceeds from a qualified account 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 (all pretax) in a traditional IRA and $25,000 in a brokerage account. Her current marginal tax rate is 25% and she expects it to remain there. What would she have after 5 years if she converts her traditional IRA to a Roth IRA and uses proceeds to pay the taxes? How would that compare with using money from her brokerage account to pay for the conversion? (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 federal income taxes, and does not take state income taxes and other tax considerations or inflation into account.)
If Elaine uses money from her brokerage account to pay taxes on the conversion, she could wind up with nearly $1,500 more in her Roth IRA after 5 years. That's because returns on money in the brokerage account are reduced by taxes (for example, taxes on dividend and interest distributions), while returns on money in her Roth IRA are not—they earn a pretax rate of return. So, using the brokerage account to pay for the taxes due from the conversion means her remaining assets in the Roth IRA earn the higher, pretax rate of return. Using conversion proceeds to pay the taxes means that less of her total assets earn the higher, pretax 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 5 years, that too would increase the benefit of using assets other than proceeds from the IRA to pay for conversion. That said, always consider the broader context: If, for example, the money in the bank account is your emergency fund, using it for a Roth conversion may not be appropriate, despite the benefits.
Read Viewpoints on Fidelity.com: Tax-savvy Roth IRA conversions
Any evaluation of a potential conversion should include input from a financial advisor, along with a tax and/or estate planning attorney.
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