Roth IRA conversion

Understand the tax and savings implications of a Roth IRA conversion.

  • Private Wealth Management

What is a Roth IRA?

With a Roth IRA, you make contributions with after-tax dollars. That means your money can potentially grow tax-free, and during retirement, your withdrawals are tax-free if certain conditions are met. More on that below.

What is a Roth IRA conversion?

A Roth IRA conversion occurs when an account owner transfers or rolls over savings from a traditional IRA (or other non-Roth IRA) or an employer-sponsored retirement program (e.g., 401(k), 403(b), or 457(b) account) into a Roth IRA. The account owner adds the taxable amount of the converted account to their income tax calculation in the year of conversion.

The idea of paying taxes "up front" may, at first glance, seem to fly in the face of conventional tax planning, which tends to argue against paying a tax today that can be deferred until a later date. This conventional thinking shouldn't be totally discounted within the context of considering a Roth IRA conversion. However, there may be circumstances where, despite an increase in current-year taxable income, it could be a worthwhile step to consider over the long run.

Advantages of a Roth IRA

  1. Tax-free withdrawals
    While traditional IRAs allow for tax-deferred growth of retirement assets, Roth IRA assets can be withdrawn tax-free, as long as assets are held within a Roth IRA for a 5-year aging period and at least one of the following conditions has been met:

    The owner is at least 59½ years of age.
    A distribution is made to a beneficiary after the death of the original Roth IRA owner.
    The distributing Roth IRA owner is disabled under the applicable IRS definition.
    The distribution is for a qualifying first-time home-buyer 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 72*. 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.
 

But a Roth IRA conversion isn't necessarily right for everyone. It depends on the IRA owner's retirement timeline, both current and anticipated tax brackets, estate plans, and cash flow. You should consult your attorney or tax advisor with regard to your personal circumstances.

Retirement timeline

If the IRA owner anticipates that the funds under consideration for a Roth conversion will be needed within the next 5 years, and the owner hasn’t previously funded a Roth IRA, a Roth conversion may not be a good 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.

Projected future tax bracket

If the IRA owner foresees their income falling significantly enough in a future year to decrease the owner's marginal tax rate, they might consider postponing a Roth IRA conversion until that lower-income year. On the other hand, if the IRA owner expects to be in the same or a higher tax bracket in retirement, consideration could be given to an earlier conversion.

Estate planning objectives

Beyond income taxes, high-net-worth taxpayers may find that converting at least part or all of a traditional IRA to a Roth IRA can be advantageous for estate planning purposes, particularly if the IRA owner doesn't expect to tap the balance during their lifetime. The assets held in a Roth IRA will be included in the calculation of the owner's gross estate, but because there are no RMDs during the Roth IRA owner's lifetime, the value of the account has the potential to grow larger than it otherwise would under traditional IRA distribution rules. This could ultimately leave more for the owner's heirs to withdraw on a tax-free basis over their lifetime.

Availability of funds to pay income taxes

The benefits of a Roth IRA conversion can be enhanced if the additional income taxes triggered are paid out of assets other than retirement assets. This would generally result in a larger sum of funds that could grow on a potentially tax-free basis, and it could enable the owner to avoid a 10% early withdrawal penalty that would otherwise apply if the owner is under age 59½. At the same time, the taxes paid will decrease the size of the owner’s gross estate. In effect, the account owner will be prepaying income tax on behalf of future beneficiaries without any of it being accounted for as a taxable gift.