Why Do a Roth Conversion?
A Roth conversion can be a potentially useful long-term planning strategy for investors looking to improve after-tax wealth in certain circumstances. While many high-income earners assume they cannot benefit from a Roth IRA because they exceed the income limits for direct Roth contributions, those limits do not apply to Roth conversions. Even if you are ineligible to contribute directly to a Roth IRA, you may still be able to convert assets from a traditional IRA to a Roth. Well-planned Roth conversions require long-term thinking, considering your entire financial plan over several years. Roth conversions may trigger significant current tax liability, may increase Medicare premiums, and may not be beneficial in all market or tax scenarios. Depending on your goals and circumstances, a Roth conversion may offer several potential advantages, along with risks and trade-offs.
Here are seven reasons to consider a Roth conversion:
1. Take Advantage of Low Tax Rates Today
Converting an IRA to a Roth may be subject to little or no additional tax in limited situations, e.g. if your income is low or your deductions are high. But zero-cost conversion opportunities are uncommon. Most often, a conversion is taxable at your marginal tax rate. So why pay tax today that you don’t have to? You may want to lock in a known tax rate today versus an unknown tax rate later. If you expect your tax rate to be higher in the future, it may, in certain circumstances, make sense to convert IRA money to a Roth before those higher rates apply.
2. Move Investments to a Tax-Free Environment
Investment earnings (dividends, interest, and capital gains) inside an IRA or Roth IRA are not taxed annually. However, IRA withdrawals typically incur income tax, whereas withdrawals from a Roth IRA are usually tax-free if IRS requirements for qualified distributions are met, including holding period and age requirements. Completing a conversion means your future growth within a Roth can compound without current taxation and may be withdrawn tax-free if qualified distribution rules are satisfied.
3. Lower the Tax Impact of Required Minimum Distributions
IRAs have required minimum distributions (RMDs), which typically result in taxable income, whether you need the money for living expenses or not. Roth IRAs do not have RMDs during the account owner’s lifetime. When you convert some of your IRA to a Roth, you may reduce future RMD amounts, which may lessen taxable income in retirement.
4. Reduce Medicare Premiums
For those on Medicare, Part B and Part D monthly premiums depend on income. Individuals with higher gross income pay higher premiums under IRMAA, the income-related monthly adjustment amount. IRA RMDs increase your gross income and can increase this surcharge. If you convert to a Roth before the surtax applies and reduce your RMDs, you may, in certain situations, reduce future surcharges; however, conversion income itself may increase premiums in the year(s) of conversion.
5. Create Plan Flexibility for the Future
If you have a large expense in retirement and need to tap into your IRA to fund it, you could create a significant tax liability and potentially even move into a higher tax bracket. This could snowball into an even larger cost if you need to withdraw additional funds to cover the tax owed on the money you took out in the first place. Converting some of your IRA to Roth can provide more flexibility when choosing where to draw funds from, which may provide additional options for managing taxable income.
6. Ease the Tax Burden for a Survivor
Widows and widowers may face higher tax rates than married couples due to what is often referred to as the “survivor’s penalty.” Converting while both spouses are alive may, in certain cases, help alleviate some of this burden if it lowers the survivor’s taxable income from IRA RMDs.
7. Benefit Your Heirs
If your heirs inherit your IRA, they will likely owe tax on distributions. They may also have to deplete the IRA within 10 years, which could create a large tax burden. If you want to “prepay” taxes as a gift to help the next generation, converting while you are alive means your heirs could inherit Roth assets that may be distributed income tax-free if applicable rules are met rather than taxable IRA assets. Paying the income tax on the conversion yourself may also reduce your estate for estate tax purposes.
IRA to Roth conversions can offer potential advantages, but the strategy is not right for everyone and every situation. Conversions come with costs and are irrevocable.
The good news: conversions do not have to be all-or-none. You can complete partial conversions over several years, or convert in years where income is lower and avoid conversions in years when income is higher. Timing decisions should consider tax impact, market conditions, and personal circumstances. With the right financial planning tools and experienced advisors to help guide the conversation, you can explore your options in the context of your personal goals and needs.
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment or tax advice from Savant. Please consult your investment or tax professional regarding your unique situation.
Kevin R. Webber
Financial Advisor
CFP®