The somewhat hidden ability to transfer a traditional IRA into a Roth IRA has recently become more publicized by the media. Whether you are someone who makes too much to fund a Roth IRA, or you’re a person who has substantially more money in a traditional account and want to diversify, there are some things to consider before moving forward.
What is a Roth IRA conversion?
A Roth IRA conversion is a process of moving assets from a traditional IRA or 401(k) into a Roth IRA. You pay taxes on the converted amount at your current tax rate; however, your account still grows tax-free and your withdrawals at retirement will also be tax-free.
Benefits of converting
Roth IRA withdrawals are tax-free. Moving money to a Roth IRA will allow you to pick and choose the pots from which you want to withdraw money. Some people may choose to withdraw traditional IRA money up to a certain point (perhaps a certain taxable level) and then withdraw Roth money to make up any shortfall. Note that you must wait at least five years to withdraw earnings from a Roth IRA even if you’re older than age 59½.
No minimum distribution required. Even though the laws have changed around required minimum distributions (RMD), the more you have in traditional accounts, the more you will be required to withdraw. Money you have in a Roth IRA isn’t subject to minimum distributions, so you can choose to manage your withdrawals when they best suit you.
Tax-free inheritance. With a Roth IRA, your beneficiaries may be able to avoid the tax collector when they receive their inheritance. While the Roth is not subject to RMDs during your lifetime (and won’t be if you leave it to your spouse), your children or other beneficiaries will have a period of time to take distributions. As long as they follow the rules, they will pay no taxes.
Who should consider a Roth IRA conversion?
You currently make too much to contribute to a Roth IRA. There are certain limits that you must fall within to contribute to a Roth IRA. In 2023, if your modified adjusted gross income exceeds $153,000 for single filers, or $228,000 for married couples filing jointly, you may not contribute to a Roth IRA. However, you may still convert all or part of an existing traditional IRA to a Roth.
You’re having a low earning year. When you convert your traditional IRA, you must pay taxes. If you find yourself making less, you may be able to convert the IRA without worrying about the added income jumping you to another tax bracket.
Your tax bracket will be higher at retirement. If you believe your tax bracket will be higher when you retire, you will end up paying that higher rate on your traditional IRA withdrawals. By converting your IRA now, you pay a lower tax rate and then will pay no taxes on your Roth withdrawals during retirement.
You’re overloaded on traditional retirement accounts. While there’s no perfect answer, most financial planners think you should have a mix of taxable and tax-free income at retirement. If the vast majority of your income will be taxed, converting to a Roth may provide more flexibility when you retire.
When you may want to pass on a Roth IRA conversion
You will need the money within five years. As noted above, you must wait at least five years before withdrawing earnings from your Roth accounts. So if you’re nearing retirement, or already retired and will need the money, a conversion may not be the best solution. Even if you have five years, consider whether your account will have time to make up for the taxes you paid to convert.
You don’t have ready cash to pay the taxes. The best option for converting your accounts is to pay taxes with outside money, that is money that isn’t part of the account you’re converting. Fortunately, you don’t have to convert 100% of the money you have in a traditional account in one fell swoop. You may want to work with a tax professional or financial advisor to determine how to convert in the most tax-efficient way possible.
Income from the conversion will bump your bracket. If you’re not yet retired and choose to convert your account, you may find that you’re suddenly in a higher tax bracket than the year before, which may affect your ability to claim tax credits or deductions. However, if you’re retired be extra careful. Not only can if affect your taxes, but it may raise the cost of Medicare.
This may be a time to consult with a professional
I’m very much a do-it-yourself financial planner. However, given the moving parts of a Roth conversion, it will be to your advantage to understand what you may achieve by completing the conversion and what affect it will have on your taxes. Having money in both types of accounts can give you flexibility, but you could end up paying too much to achieve that flexibility if you don’t fully understand the costs and benefits particular to you.