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Converting to a Roth IRA: When Does it Make Sense and What are the Benefits?

By Razi Hecht, Wealth Advisor

and Scott Dillie, CFP®, Wealth Advisor

When does it make sense to convert a Traditional IRA to a Roth IRA? Most of us are familiar with Traditional IRAs, where money is invested pretax and taxes are due when money is withdrawn. Traditional IRAs also require regular distributions (required minimum distributions or RMDs) in retirement.

The newer Roth IRA was introduced just over 20 years ago (followed a little later by the Roth 401k) and allows retirement savers to put away money for retirement without a tax deduction on the contribution up front. Roth IRAs allow tax-free withdrawals and no requirement that RMDs be taken.  This can allow money to grow tax free for a very long time.

Until recently, contributions to Roth IRAs were limited to those under certain income thresholds.  But now, individuals can contribute to a Traditional IRA or 401(k) and then do what is called a “back door” conversion.  There is no longer an income cap on conversions.

Individuals can convert Traditional IRAs to Roth IRAs without incurring the 10% penalty for withdrawing money from an IRA before age 59 ½.  However, converting from a Traditional IRA to a Roth IRA triggers income taxes on the amount converted.  Determining whether a Roth IRA makes more sense than a Traditional IRA depends on a lot of factors, including future tax rate, investment returns, inflation and how long you will live.  Regardless of the decision of whether or not to convert IRAs, we encourage investors to consider including both forms of IRA in their retirement portfolios.

When planning for retirement, it is important to think in terms of sources of income in retirement – social security, 401(k) or 403(b) retirement accounts, IRAs, and other investments.  To maximize after-tax outcomes, we encourage individuals to create a variety of buckets that they can draw from – some that are taxable and some that are tax free.  Tax savvy investors can tap tax-free sources of income in years when income is higher and draw down taxable Traditional IRAs in years when income is lower.

Talk to your advisor about your own tax situation, but if you find that it makes sense to convert a portion of your Traditional IRA to a Roth IRA, keep in mind the following tips and considerations when converting:

Converting post-retirement – Generally speaking, investors seek to convert at a time when their income is lower or when the extra income they will report won’t push them into a higher tax bracket.  For example, a recently retired couple who is not yet drawing on social security or required to take RMDs from their Traditional IRAs may have very little taxable income.  They can try to fill up those lower tax brackets in their early retirement years knowing that, once they start taking RMDs, they will be in a higher bracket.

Consider unintended consequences of reporting the higher income after a conversion – Those who may be eligible for certain child tax credits should consider carefully how much they can convert without crossing the thresholds that may make them ineligible for those tax credits.  It may still be a good time to do a conversion, but it may increase the cost of doing so.  Another potential surprise would be for couples in or approaching retirement who may be enrolled in Medicare Part B. Keep in mind that the additional income claimed due to a conversion could cause the premium to increase.

When business is down – Business owners can often plan a conversion when income is down or in a year when they report a loss.  If, for example, a business owner is normally in the 37% bracket but will be in the 24% bracket during a challenging year, it could be a good opportunity to convert a portion of a Traditional IRA – but not so much that you land in the higher tax bracket.

Be careful with designating beneficiaries on a Roth IRA – Generally it is best to name a spouse as a beneficiary on a Roth IRA versus a trust. A trust would be required to take RMDs starting immediately while a spouse wouldn’t, eliminating one of the key flexibility benefits of the Roth IRA.

Pay attention to state taxes – Traditional IRA distributions are taxable at the state level.  When evaluating a Roth conversion, pay attention to future tax rates as well as current.  If someone lives in a high tax state and plans to move to a state without state income taxes, it may make sense to time the conversion accordingly.

Avoid withholding – Be aware that if you withhold taxes during a conversion, you limit the impact; fewer dollars are then invested in the Roth IRA.  The best-case scenario is to pay the taxes separately out of other funds instead of reducing the amount.

Legacy benefits – Families likely to have enough retirement assets set aside to pass on an IRA to the next generation can reap significant rewards with the Roth IRA. Children and grandchildren are required to take RMDs and are likely in lower brackets than their parents.

For Widows or Widowers –When one member of a couple will predecease the other, income for the surviving spouse may not change significantly, but the bracket will be cut in half when the surviving spouse files a single tax return.  Here it can be very helpful to be able to draw from a Roth IRA.

Last chance to do a recharacterization – Investors historically thought carefully about the timing of a Roth IRA conversion, and the tax law used to allow individuals to back out of a conversion or “recharacterize” their IRA if it made sense or if their tax situation changed. Unfortunately, the Tax Cuts and Jobs Act of 2017 eliminated the ability to recharacterize a Roth IRA conversion. This was a pretty significant change and will limit a fairly common practice.

Every individual tax situation carries its own implications which may or may not warrant a conversion strategy. We encourage anyone considering a Roth IRA conversion to talk to their financial advisor before doing so.

Bronfman E.L. Rothschild, LP is a registered investment advisor (dba Bronfman Rothschild and Bronfman Rothschild Wealth Advisors). Securities, when offered, are offered through an affiliate, Bronfman E.L. Rothschild Capital, LLC (dba BELR Capital, LLC), member FINRA/SIPC.
Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP®, Certified Financial Planner™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements. 
This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Bronfman E.L. Rothschild, LP cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. Past performance does not guarantee future results.
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