Since 2010, high-income investors looking for continued tax-deferred 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 . 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 Roth assets 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.
If these criteria are not met, the withdrawals will generally be subject to a 10% penalty for early withdrawal. If earnings are withdrawn in addition to the withdrawal of the converted balances with the above criteria not being met, those earnings will generally be subject to a 10% penalty for early withdrawal, as well as income tax.
2. No required minimum distributions. Roth assets do not require annual required minimum distributions (RMDs) after the owner reaches age 73. 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. (Note: Earnings may still be taxable as income if the applicable 5-year aging rule has not been satisfied. Inherited Roth assets may be subject to RMDs.)
3. Tax diversification.The Roth as assets may provide a vehicle for tax diversification of retirement assets, providing more flexibility in managing the owner's investments, withdrawals, and estate composition.
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, a Roth conversion may not be a wise choice. This is because of the 5-year aging period required for each conversion and the ordering of Roth withdrawals. While you may have made an initial Roth contribution that satisfies the 5-year aging period required to withdraw earnings tax free, conversions must be withdrawn first, and if they have not met their own 5-year aging requirement, they may be subject to a 10% penalty.
Are you prepared to pay now?
When converting originally nondeductible assets to a Roth, you may 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 conversions of IRA assets and the conversions of workplace plan assets.
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, even if you don’t have cash available, if you've experienced an unusual dip in income over the last 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 and tax rates?
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 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. Similarly, if you expect tax rates to rise in the future, a Roth conversion this year may make more sense than converting when tax rates are higher in the future.
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 inherited a Roth or traditional IRA or a 401(k) on or after January 1st, 2020, 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 would protect inheritors from federal taxes, greatly increasing the potential for additional tax-free growth.
Could you do a backdoor Roth IRA conversion?
A "backdoor" Roth IRA conversion is achieved by first contributing after-tax dollars to traditional IRA, 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.