Blaine Thiederman MBA, CFP | September 23, 2022

4 Considerations to Make Before Doing a Roth Conversion

There are two common types of individual retirement arrangements (IRA) that you can invest in when saving for retirement: a Roth IRA and a Traditional IRA. When reviewing some of their differences, it’s important to ask yourself: “When should I be trying to defer taxation on my income or lock in my current tax rate and recognize more of it on my return?”.

We often have conversations with clients about Roth conversions and whether or not it makes sense for their situation. Typically, this question comes up when someone is starting a new job and considering what to do with their existing IRA and enrolling in a new plan. Should you enroll in your 401k and start saving in that or should you continue saving in your IRA? The hard part of answering those questions is, it really depends. We’re discussing what you need to know below. 

What’s the difference between a Traditional IRA and a Roth IRA?

A traditional IRA account is created using pre-tax dollars, meaning the distributions you take from a traditional IRA account in retirement is taxable income.

A Roth IRA is funded using after-tax dollars (money that you’ve earned, paid taxes on, and is likely sitting in your bank account). All distributions you take from Roth IRAs in retirement are tax-free (because tax has already been paid) so long as the funds have been in the Roth over 5 years and you’re over 59.5 in retirement.

An additional reason why Roth IRAs are so valuable is that they also don’t have required minimum distributions, meaning that the government won’t ever require you to take money out of them for any reason. This means that your funds can be left in there to continue to grow tax-free until you need them, like when you potentially enter a retirement facility or have major medical bills in your 80s. This benefit can be life-changing.

It’s important to have tax diversification in your retirement assets so you have more flexibility in how you manage your taxes in any single year in retirement. IRA accounts have a variety of different tax benefits and, like a toolbox can be used for different purposes.

What Is a Roth Conversion?

A Roth IRA conversion refers to the act of converting a traditional IRA account into a Roth IRA account. It’s considered a qualified distribution (tax-free) of the IRA owner’s either non-deductible contributions or deductible contributions (which would be taxable and part of your gross income).

When you convert deductible contributions, you’ll have to include the converted amount in your ordinary income meaning IRA owners pay additional taxes on this dollar amount, and may or may not make sense based on your specific situation. This isn’t tax advice so don’t act on this without talking to a qualified tax advisor.

Why would you convert IRA contributions to a Roth rather than just do a Roth IRA contribution?

If you earn over the income limits for the calendar year, you aren’t allowed to do any Roth IRA Contributions. The income limit changes every year and is dependent on your tax filing status so it’s important to pay attention to this prior to making a contribution to a Roth IRA.

The question is if you earn over the limit, is there any way to get money into a Roth IRA that’s perfectly legal? The answer is, yes and it’s called a Backdoor Roth IRA. Keep in mind, this isn’t legal advice nor are we saying this is a good idea. There’s a lot to a Backdoor Roth IRA so be sure you talk to a fiduciary financial planner before you take action on this and take their advice.

The conversion process for using a Backdoor Roth IRA is as follows:

Step 1. Verify if you have any money in IRAs. If you don’t have any money in an IRA, move on to step 2.

Step 2. Make a non-deductible contribution to a Traditional IRA (i.e. elect to not receive a tax deduction when you make the contribution) held at your preferred financial institution and file form 8606 reporting the contribution as nondeductible.

Step 3. Don’t invest your money in the Traditional IRA.

Step 4. Set up a Roth IRA.

Step 5. File a “Roth Conversion Request” to convert your funds from your Traditional IRA to your designated Roth account.

Step 6. Invest your funds within your Roth IRA in whatever investment products make the most sense for you. If you don’t know which investment products make the most sense, contact a financial planner and get investment advice.

Result: So here’s the good news. So long as you don’t touch the funds for the longer of 5 years or when you turn 59.5, you won’t have any tax consequences when you withdraw the converted balances. This could benefit your retirement income strategy because tax-free growth and the ability to take a tax-free distribution are never bad things.

But wait! It gets BETTER. If your income in retirement is low enough because you have so much in Roth IRAs, your social security will ALSO be non-taxable.

It gets EVEN better! Roth IRAs have no Required Minimum Distributions which means they give you more control over your future tax circumstances in the long run.

The Drawbacks to Roth Conversions

You could owe a huge amount of federal taxes on your federal income tax return as a result of the conversion. If you converted 100k in one year and pay a 49% effective tax rate as some people do, you could owe $49,000 which is a big tax bill so, be sure to talk to a tax professional or your financial advisor before making the decision to do a Roth Conversion.

The Pro-Rata Rule also makes this tough because if you do a nondeductible contribution to an IRA and you have 3 other IRAs which much larger balances, your conversion won’t be separated from the total balance. Even if you didn’t take a deduction for the contribution (after-tax money), you’ll pay taxes on the majority of the whole thing, so, as I said, talk to a tax professional before making the decision to convert anything otherwise, you may be subject to tax-penalties and that could be terrible.

What if you withdraw part of a Roth Conversion before the five-year clock is done ticking? You’ll have major tax penalties on the earnings portion of the withdrawal.

What if you want to make a huge withdrawal from your Roth IRA before 59.5 but more than 5 years from your contribution? You’ll have a tax liability that again depends on the earnings portion of the withdrawal assuming it’s not for a first-time home purchase, as a result of death or disability.

The point is, be careful when you’re making a withdrawal. If you’re not sure what to do, talk to a tax professional or a financial planner before you to avoid making a mistake.

What happens to the retirement savings you have in a Roth IRA if you die?

It really depends on who your beneficiary is.

If your spouse is your beneficiary, they have a few options.

Option 1. They can withdraw it all to pay for expenses, penalty and tax-free. This may be helpful if you don’t have any life insurance and they can’t afford all the bills without it.

Option 2. They can open up their own Roth IRA and roll the funds over into it, prolonging the tax-free growth but now having to ensure they avoid withdrawals until 59.5.

Option 3. Your spouse can open an Inherited IRA and deplete the account within 10 years as per the Secure Act.

Make sure before you make a decision on which option makes the most sense for you to ensure you have a good reason for doing what you decide.

Considerations to Make Before Doing a Roth Conversion

While a Roth conversion could be a great option for some, it could be a costly mistake for others. For this reason, we’ve outlined 4 extremely important considerations you have to make before converting your Traditional IRA into a Roth IRA.

#1: Your Timeline to Retirement and Your Retirement Plan

If you’re retiring within the next few years, you may want to forego a Roth conversion. Why? Because the money you convert from your Traditional Individual Retirement Account into your Roth IRA must stay there for a five-year holding period. If withdraws are made before the five years are up (five-year rule), you could be hit with a 10 percent early withdrawal penalty and/or additional income taxes that you’ll have to pay when you file your tax return.

#2: Tax Obligations

When considering a Roth conversion, you simply can’t ignore the tax implications associated with this move. While everyone’s preference may be not paying taxes in retirement, you’ll have to pay taxes on your income at some point (even if you defer it for a bit). Planning for your tax future is incredibly valuable because as you pay tax on the additional income you receive, it could very well push you into a much higher tax bracket. While it’s possible to cover the difference using a portion of the distribution itself, this is typically not advised for two reasons: you’d be robbing your future retirement of income and you may be subject to a 10 percent penalty for taking the funds. 

#3: Your Future Tax Bracket

One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement. Given the fact that you’ll get tax-free withdrawals, you’ll want to plan your tax future out considering whether you expect to be in a higher or lower tax bracket in retirement when you withdraw these Roth funds. If you think you’ll be in a lower tax bracket once you’re retired, it’s probably a good idea to wait to withdraw the funds until then. Alternatively, if you find yourself out of work, unemployed, disabled, or just plain unable to earn income for a short period… you probably aren’t gonna make as much that year meaning you may pay no taxes at all. This is probably a good time to consider a potentially large Roth Conversion.

#4: How Much to Convert and When

If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. For example, if you earned 20k less than the top of your tax bracket but the next highest marginal tax bracket charges 25% or more, you could convert 20k of IRA funds every year, paying only 12% taxes on every conversion… until your whole IRA is in a Roth and as a result, now grows tax-free.

Let’s be honest: who doesn’t want tax-free income in retirement? Fewer taxes are more affordable than more taxes. It’s good to know that while you may have chosen to open a traditional IRA years ago that you have the option to change your mind and convert it at any time. We encourage you to reach out to our team with questions and to discuss what is best for your financial situation.

Conclusion

As with all things in financial planning, there are a lot of “ifs”, “and”, “Maybes” and “sometimes”. If this article seemed at all confusing to you, that’s okay. You’re absolutely not alone. Before deciding to do a Roth Conversion, if you aren’t sure what to do, talk to a tax professional or set up an appointment with Progress Wealth Management by clicking below. We’re happy to help you at no cost. We hope this article was helpful.