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Making Sense of Roth Conversions

As a retirement investor, doesn’t it make perfect sense to own a Roth IRA? Tax-free growth and withdrawals. No required minimum distributions. What’s not to love?

By believing that you must rollover all or a portion of your money from a traditional IRA to a Roth IRA, known as a Roth conversion, you may be falling for the fallacy that the grass is always greener. Whether or not a Roth conversion makes sense depends on your current and future finances; sometimes the investment accounts you already own are the right ones for you.

Essentially, a Roth conversion is a tax issue. Should you pay taxes now for potential tax savings in the future? Taxes, of course, are a drag on your investment returns much like investment costs. The goal should be to minimize both. However, while keeping investment costs low can be done the same way by everyone, managing taxes is predicated on a variety of personal factors. Here are some important considerations for your decision about converting to a Roth IRA.

Current and future tax rates

Arguably, the most important question to answer about a Roth conversion is: will my tax rate be higher or lower when I start drawing down my accounts? Remember, traditional IRA contributions are pre-tax and withdrawals are taxed as income; Roth IRA contributions are after-tax and withdrawals are tax-free. So, if you anticipate being in a higher tax bracket in the future, then a Roth conversion may make sense. For example, let’s say you’re in a 10% or 15% tax bracket today and expect to be in a 25% or higher tax bracket in the future. Your tax bill could be lower by converting to a Roth IRA than it would be when withdrawing money later from a traditional IRA.

Conversely, if you expect a lower future tax rate, then a case can be made for sticking with a traditional IRA. For example, a lawyer or doctor at the top of his or her pay grade very well could be in a lower tax bracket in retirement. In that case, the future Roth IRA tax benefits may not be worth the high tax bill today.

There is one wild card to also consider: Congress. Congress can always change the U.S. tax code and revise tax rules for Roth IRAs. While it’s impossible to know what Congress will do in the future, retirement investors should be mindful of how possible legislative changes affect their tax rates.

Minimizing RMDs

Required minimum distributions (RMD) force money out of your investment retirement accounts and are taxed as ordinary income. Depending on your IRA balances, they could even place you in a higher tax bracket. You could liquidate your IRAs before you turn 70 ½ years of age to avoid RMDs completely, but that means also sacrificing the tax-free growth. (Of course, you would only want to do this if your current tax rate is lower than your expected future tax rate since IRA distributions are treated as taxable income.)

Instead, a Roth conversion can effectively minimize your RMDs. Roth IRAs have the unique benefit of not being subject to RMDs. You must decide whether the potential tax savings on RMDs later makes up for the tax liability you pay now. An alternative is lowering the amount of your RMDs by converting a portion of your IRAs to a Roth IRA.

Ultimately, none of this matters unless you live long enough – specifically, beyond 70 ½ years of age when RMDs begin – to take advantage of the benefit. Additionally, once an IRA owner dies, all IRAs, including Roth IRAs, are subject to RMDs for beneficiaries.

Paying taxes on a Roth conversion

If you’re under the age of 59 ½ (the age restriction for early withdrawals), you should have funds available outside of the traditional IRA to pay the taxes on the conversion. If not, paying the tax with money out of the IRA is considered a non-qualified distribution and can result in an additional 10% early withdrawal penalty.

Taking contributions to the limit

An advantage of a Roth IRA is that it lets you shelter more after-tax money than a traditional IRA. Consider that a $5,500 contribution (the annual 2014 contribution limit for traditional and Roth IRAs for people under 50 years; $6,500 for those 50 years or older) to a traditional IRA at a 25% tax rate is really $4,125 since the government owns $1,375 in the form of the tax liability upon withdrawal. Further, if your taxes rise in the future, the government’s portion increases. Again, you must determine whether this advantage is worth the tax bill paid now compared that of the future.

Don’t trip through the “back door”

If you’re a high-income investor, you may have found yourself excluded from IRAs and their tax deductions. Roth IRAs, for example, have income limits of $129,000 (single) and $191,000 (married, filing jointly) in 2014. IRA deductions are not allowed if you are covered by an employer’s retirement plan and have an income equal or greater than $70,000 (single) or $116,000 (married, filing jointly) in 2014.

Nonetheless, you can access a Roth IRA via what is commonly called the “back door.” Simply, you contribute to a nondeductible IRA and then convert it to a Roth IRA. However, if you have other IRAs (SEP IRA, rollovers, traditional, etc.), especially ones in which you’ve made deductible contributions, you can create a large tax liability. That’s because the taxable portion of any Roth conversion you make is calculated based on the balance of all your IRAs, not just the one you wish to convert. This is commonly known as the IRS “pro rata rule.”

Estate planning

If you’re fortunate enough to not need all or a portion of your money for retirement, Roth IRAs are well structured for leaving money to an heir. The money you pass on to beneficiaries in an inherited Roth IRA can continue to grow tax-free. Your heirs will still have to take an RMD, but it will not be a taxable event. Thus, Roth IRAs may make sense in your estate planning decisions.

Further considerations in retirement

There are a few Roth conversion considerations that pertain specifically to investors already in retirement. One, when you start receiving Social Security your marginal tax rate may rise as each dollar of additional income increases the percentage by which your Social Security benefit is taxed. Additionally, a widow or widower may fall under a higher marginal tax rate after their spouse dies as they change tax filing status and he or she receives the larger Social Security benefit between the two as well as their collective investment income. Finally, if a Roth conversion changes your income level, it may affect your Medicare premiums, which are based on your Modified Adjusted Gross Income.

Making sense out of the rules along with the potential benefits and shortfalls of Roth conversions can be difficult for retirement investors. Some try to get the best of both worlds by holding money in traditional and Roth IRAs, if possible. Unfortunately, there is not a one-size-fits-all policy for Roth conversions. Whether or not it makes sense for you is predicated on your specific tax situation and financial goals Therefore, we recommend you seek the help of your tax adviser before making these decisions.