You are here

Roth Conversions: To Convert or Not to Convert Your Traditional IRA

The discussion of whether to convert your IRA to a Roth IRA evokes a wide range of opinions regarding if, when, and how you should convert the assets in your account. Some advisors believe you should always convert all your Traditional IRA (also called a Contributory IRA) assets to a Roth, while others feel you should never convert. The truth lies somewhere in between.

It’s important to understand the different tax treatment of IRAs. A Traditional IRA is funded by making contributions, and if you qualify under IRS rules, you can deduct your contribution from your taxable income. You get the tax break up front, but when you take the money out of the account in retirement, your contribution and the profits are fully taxed as income. A Rollover IRA acts in much the same manner. You got the tax deduction when you contributed to your retirement plan, before you rolled that money to a Rollover IRA. When the money comes out of the account in retirement, it is fully taxable as income.

Tax-wise, Roth IRAs act in a manner opposite to Traditional IRAs. The money you put into a Roth IRA from the conversion has already been taxed - it is taxed when it is taken out of the Traditional IRA and moved to a Roth IRA account - but the investment grows tax free from then on, and comes out of the account completely tax free when you take distributions. When considering converting to a Roth IRA, it’s important to keep in mind that if you are under 59 ½ and withhold state or federal taxes when converting, that could be considered a premature distribution, and trigger a 10% penalty on the withholding. You will need to plan for the additional federal and possibly state taxes owed for the tax year you convert to avoid any penalties and interest.

Paying taxes now as opposed to later may sound unpleasant, but that depends on your tax situation now and in the future. Let’s look at three basic scenarios (which are based on current tax laws):

  1. You expect to be in the same tax bracket for the rest of your life: In this scenario, a Roth Conversion does not make much sense. The added income from the conversion could push you into a higher tax bracket, causing you additional taxes. At best, you make the conversion, pay the taxes, it grows until you take it out at the same tax rate, and you end up with the same amount of money as if you did nothing in the first place.
  2. You are in a higher tax bracket now and will be in a lower tax bracket in retirement: Under this scenario, you are paying a higher rate of taxes now. If you wait until retirement you will be taxed at a lower rate. Therefore, by paying taxes now, you have less money to grow tax free. Moreover, when you withdraw the money, you will have less than if you had kept it in the Traditional or Rollover IRA. A Roth Conversion doesn’t make sense for you.
  3. If you are in a low tax bracket now, but will be in a high tax bracket in the future when you expect to take withdrawals: This is where converting now makes sense. You pay less tax now converting the funds than you would withdrawing from a Traditional or Rollover IRA later in retirement. In this scenario, you end up with more money in your pocket. As an added benefit, you do not have to make required minimum distributions.

Another argument for a Roth Conversion is that taxes are going up.  Tax laws are always changing, but when planning for the future, you need to use current law as a basis for your decisions - we don’t know what tax law will be 10, 20 or 30 years from now, especially for the majority of people in lower tax brackets. If you are in the highest tax bracket and always will be, then a conversion may make sense.

Keep in mind that you do not have to convert your entire IRA to a Roth. Doing a partial conversion makes sense if you will be pushed into a higher tax bracket by converting the whole IRA.

Other Considerations:

  1. If you do not need the money, and you intend for it to go to children or heirs in high tax brackets, consider paying the tax now, so your children get tax-free distributions later. Your heirs will be required to make required minimum distributions each year.
  2. If you plan to have your IRA money go to charity, then converting to a Roth will actually cost your charity money. Charities do not pay taxes on IRA donations when they are withdrawn, so in this case do not convert.
  3. If you have children in college or who will soon go to college, the added income on your tax return from a Roth Conversion can affect student financial aid.
  4. Annuities in IRAs with insurance features pose a whole new set of complications. You should consult your financial advisor and tax professional before doing a conversion.
  5. In regular Roth IRAs, you are able to withdraw the principal at any time, tax and penalty free. If you convert money to a Roth IRA and are under age 59½, you can't withdraw the Roth Conversion contributions for five years. If you do, you'll face a 10% penalty. (The rules for distributions of earnings are the same as with direct contributions.) There are exceptions for this rule for first time home buyers and certain hardships.
  6. IRS’s Pro-Rata rule: If you made non-deductible contributions to your Traditional IRA, you cannot separate the non-deductible portion of the IRA from the deductible portion. In other words, you can’t separate the coffee from the cream once mixed, even if you have separate IRAs for the different types of contributions, they are considered one IRA together when converting. 
  7. It’s important to know that converting increases your taxable income, which means if you are covered under Medicare, the rates you pay for Medicare Part B and Part D Prescription Drugs may go up.

There are many factors to take into account when deciding if a Roth Conversion is right for you. With so many rules and considerations, this short article just begins to cover the basics. Please contact a Portfolio Solutions® Financial Advisor to learn more.   

The information contained herein cannot be relied upon for tax reporting purposes. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

At Portfolio Solutions®, we design, implement, and maintain dedicated portfolios using low‐cost, passive investing methods so our clients keep more of what the global markets offer. We would rather see investors earn more by controlling their investment costs than by taking unneeded, additional risk in their portfolios.