Since 2010, high-income investors looking for tax-free growth potential and tax-free withdrawals in retirement have had the option of converting assets in their traditional IRA or employer-sponsored retirement plan to a Roth IRA. Whether or not this is a good idea for you depends on your retirement timeline, your current and anticipated future tax brackets, your overall estate plan, and your current cash flow.
Why convert?
Converting assets in a traditional IRA or employer-sponsored retirement plan to a Roth IRA has several advantages:
a. The owner is at least 59½ years of age.
b. A distribution is made to a beneficiary after the death of the original Roth IRA owner.
c. The distributing Roth IRA owner is disabled under the applicable IRS definition.
d. The distribution is for a qualifying first-time homebuyer expense, up to a $10,000 lifetime maximum amount, per individual IRA.
If these criteria are not met, a Roth IRA owner will generally be subject to tax, and possibly an additional 10% penalty for early withdrawal. However, withdrawals of contributions from a Roth IRA are generally tax-free.
2. No required minimum distributions. Unlike a traditional IRA, a Roth IRA does not require annual required minimum distributions (RMDs) after the owner reaches age 73.1 That means that the Roth IRA may, in certain situations, be used as an estate planning tool, because the assets may potentially be passed on income tax-free to beneficiaries.
3. Tax diversification. The Roth IRA may also serve as a vehicle for tax diversification of retirement assets, providing more flexibility in managing the owner's taxable income after their working years are over.
These may be attractive attributes, but before you make the decision to convert, consider the following questions.
When do you intend to retire?
If you are going to need the assets you're thinking of converting within the next 5 years and you don't already have a funded Roth IRA, a Roth conversion may not be a wise choice. This is because of the 5-year aging period required before any tax-deferred dollars that have built up can be withdrawn on a tax-free basis. However, it is important to note that the "aging period" is triggered by a contribution to any of an individual's Roth IRAs (which may have already occurred prior to the year of conversion).
The longer assets remain in a Roth IRA, the greater the potential tax-free earnings accumulation. Note also that while a conversion prior to age 59½ will not trigger a 10% early withdrawal penalty on the taxable amount converted, a subsequent distribution from the Roth IRA within the 5-year period that begins on January 1 of the year of the conversion may trigger a "recapture" of that penalty.
Are you prepared to pay now?
When converting a traditional IRA with nondeductible assets to a Roth IRA, you will likely also have to convert a portion of your deductible balances as well, which means some taxes will be owed at the time of conversion. The rules that govern how much of the nondeductible contributions you can convert can be complex, especially if you have multiple IRAs.
Any deductible assets included in a Roth conversion will be treated as income for the current tax year, increasing your adjusted gross income (AGI). While some investors may be able to offset this tax liability with charitable giving and tax-deductible losses, most will need to pay it with cash on hand. If you have to tap into the assets you are converting or sell other investments to cover the bill, it may not be worth the trouble.
On the other hand, if you've experienced an unusual dip in income over the last year or have the ability to implement a strategy to reduce your taxable income such as donating complex assets or accelerating planned charitable donations into the current year, this may be a good opportunity to consider a Roth conversion, as the increase in AGI is less likely to push you into a higher tax bracket.
Do you plan on moving soon?
If you have plans to move to a state where future distributions from a traditional IRA or employer-sponsored retirement plan will be taxed at a higher rate, such as California, it could be advantageous to do the Roth conversion before you relocate. However, if you're moving from a high-tax state to a lower-tax state, the tax cost of converting to a Roth may not be worth it because those future distributions would not be taxable in a state like Texas.
What are your expectations around your future income?
If you anticipate that your income may decrease significantly enough in a future year to reduce your marginal tax rate, you might consider postponing a Roth IRA conversion until that lower-income year. On the other hand, if you expect to be in the same or a higher tax bracket in retirement, it may be worth considering an earlier conversion.
Do you want to protect your inheritors from taxes?
"The Roth conversion can be quite valuable, not only from an income tax perspective, but also from an estate tax perspective," says Bryan Hwang, a vice president with Fidelity Private Wealth Management.
Following the passage of the SECURE Act, those who inherit a Roth or traditional IRA or a 401(k) must completely withdraw all funds from the account within 10 years of the death of the original account holder, with exceptions for eligible designated beneficiaries (defined as surviving spouses, minor children, disabled or chronically ill beneficiaries, or beneficiaries who are less than 10 years younger than the original account holder). Prior to this, inheritors could stretch out withdrawals over their lifetime, taking only yearly required minimum distributions and benefiting from additional growth in the account.
Now, however, those who inherit traditional IRAs or 401(k)s are likely to pay more in taxes as they must make larger withdrawals over a shorter period. Converting those assets to a Roth IRA would protect inheritors from federal taxes, greatly increasing the potential for additional tax-free growth.
Could you do a backdoor Roth conversion?
A "backdoor" Roth conversion is achieved by first contributing after-tax dollars to traditional IRA or 401(k), then immediately converting it to a Roth IRA. As the assets have not been in the original account for very long, it's likely that the tax due at the time of conversion would be minimal, if not nonexistent (assuming you do not have multiple IRAs). While there are income limits on Roth contributions, there have been no such limits for Roth conversions, making this a popular strategy for high-income investors.
Consult a tax professional
It's important not to rush into any decision before fully considering the impact accelerating your Roth conversion could have on your overall wealth plan. Moving too quickly could result in missteps that undermine the tax-efficiency of your overall strategy. Before you determine your next step, consult with your tax advisor and accountant and work together to identify the best approach for your specific situation.