An overview of Roth conversions
A Roth conversion moves all or part of your traditional pretax IRA to a Roth IRA. Roth conversions are used as a tax planning strategy: accelerating income taxes due on the converted amount to create tax-free retirement account growth. Generally, amounts converted will be subject to income tax in the year converted. If your traditional IRA has after-tax contributions, any distributions, including distributions as a result of a Roth conversion, will be subject to the pro-rata rule.
Why consider a Roth conversion?
- Individuals may convert to a Roth because they believe their tax bracket will be lower today than in the future.
- Current or expected taxable income in 2023 is lower than future years.
- Pay taxes now so that beneficiaries can inherit from the Roth IRA tax-free, if certain qualifications are met.
- The SECURE Act limited “stretch” provisions. Many beneficiaries will have to take distributions of traditional IRAs over 10 years, creating more of a tax burden than the previous rule. A Roth IRA must still be distributed within 10 years however, since the distributions from a Roth account are tax free, your beneficiaries can let the Roth account grow and then take the entire distribution in year 10 with no tax consequences.
- Conversion is a planning opportunity to create tax-free income for beneficiaries. It may also be used if the beneficiary is, or plans to be, in a higher tax bracket than the IRA owner themselves when the account is received.
- Create tax diversification in retirement. Roth IRA distributions are generally tax-free, whereas traditional IRA distributions are taxable.
- Having both taxable and tax-free accounts allow retirees to adjust to future tax environment.
- Limit future required minimum distributions (RMDs) for tax bracket management. A Roth conversion will result in a smaller traditional IRA, which equates to lower RMDs.
- Roth IRA distributions do not increase counted income for Social Security or Medicare.
Conversions in a down market
Declines in the equity market create an even greater opportunity for Roth conversions. Implementing a Roth conversion while the asset values are down could result in a lower tax bill for the securities rolled over, and any resulting appreciation due to a market rebound will grow in the tax-free Roth IRA. Roth conversions may be done “in-kind”, allowing you to fully participate in any market recovery.
When implementing a Roth conversion, consider paying taxes from an outside source, allowing all of the converted funds to grow as opposed to taking a withdrawal from the plan to pay taxes. Keep in mind, distributions from an IRA when a participant is under 59 ½ may be subject to a 10% penalty.
Potential considerations of a Roth conversion
Implementing a Roth conversion means paying more taxes now, which may not be beneficial if you are in a higher tax bracket today than you expect to be in the future, or if you expect tax rates to decline. Also, Roth conversions increase your AGI in the year of conversion. This can affect other tax deductions, credits and related items, such as Medicare premiums.
A Roth conversion also isn’t beneficial if you need the distributions for immediate expenses.
Also, consider your beneficiaries. If you intend to leave your traditional IRA to a charity, it may not make sense to pay additional taxes today for money that the charity wouldn’t be taxed on upon receipt.
If you think a Roth conversion may be a good fit for your portfolio, consult with your financial advisor and tax professional to assess the pros and cons.