A Roth IRA Conversion, when done carefully, can help investors plan for a more flexible and tax efficient retirement. But, as with any process involving the Internal Revenue Code, there are plenty of pitfalls that can make a Conversion painful and inefficient.
Here’s what to consider when you’re considering if you want to do a Roth IRA Conversion.
Why Convert?
If you’ve already decided that a Roth IRA Conversion is for you, you can skip this part. If you aren’t sure – or are just curious – read on.
While some savers can make direct contributions to a Roth IRA; some cannot.
Learn more about IRAs
For those who can’t contribute directly to a Roth IRA, to access this tool they must either execute a Roth IRA Conversion or use a Backdoor Roth IRA strategy.[1]
Roth IRAs come with some key benefits that make converting potentially attractive.
Tax-free Withdrawals: When you own a Roth IRA and begin taking withdrawals in retirement, those withdrawals are tax-free. That means keeping your taxes in retirement lower and getting tax-free growth on investments.
This can be especially valuable for Medicare recipients since Roth IRA distributions aren’t subject to the Income Related Monthly Adjustment Amount rules that drive your Medicare premiums.
No Required Minimum Distributions: Unlike Traditional IRAs and 401(k)s, Roth IRAs are never subject to Required Minimum Distributions during the original account owner’s lifetime. That gives you maximum flexibility in retirement to take funds as needed or to leave them invested.
Tax-efficient Wealth Transfer: For retirees with ample resources outside of their Roth IRAs, the Roth IRA can become a valuable wealth transfer tool. Because there are no RMDs, and all qualified distributions are tax free, a Roth IRA can help you transfer tax advantaged dollars to your heirs with maximum time for tax-deferred growth.
Why not Convert?
While there are good reasons to execute a Roth IRA Conversion, there are also reasons not to proceed. Most of those reasons have to do with taxes.
Roth IRAs can only hold post-tax dollars. When you convert an existing Traditional IRA to a Roth IRA, any pre-tax dollars in the account will be taxed.
Let’s look at two scenarios.
Converting a 100% Pre-Tax Traditional IRA
For example, if you have a Traditional IRA that you funded with tax-deductible contributions, and you want to convert that Traditional IRA to a Roth IRA, the entire balance will be included in your taxable income for the year and subject to ordinary income tax at your marginal tax rate.
Let’s look at some numbers. Say you want to convert $30,000 in pre-tax dollars in 2024. Let’s also say that your taxable income for 2024 is expected to be $191,950 (filing status Single).
Before you convert, your taxable income is $191,950 and your marginal income tax rate is 24%.
After you convert, your taxable income is $221,950 and your marginal income tax rate is 32%.
That means your conversion could cost up to $9,524.[2]
If you choose to pay the taxes from the IRA, your $30,000 Traditional IRA will become a $20,476 Roth IRA in an instant.
Converting Partially Pre-Tax Balances
You may have an existing Traditional IRA that is comprised of non-deductible (read: post-tax) contributions and some investment growth. In this case, your conversion would be subject to the pro rata rule.
Let’s look at our scenario above and adjust a few key facts. Your Traditional IRA was funded with non-deductible contributions over a period of three years and those contributions totaled $16,500. Only the fraction of the balance that is comprised of pre-tax dollars is subject to taxation upon conversion.
In this case, 55% of the balance is post-tax, and 45% is pre-tax.
If you converted the full balance, $13,500 would be includable in income.
After you convert, your taxable income is $205,450 and your marginal income tax rate is 32%.
Under this scenario, your conversion could cost up to $4,244.[3]
Best Practices
If, after considering the tax consequences of a conversion, you still want to convert there are some best practices to consider.
First, consider your tax rate today vs. your tax rate later.
If you are in your prime earning years and already in a high marginal tax bracket, a conversion now may not be wise. It might be better to wait until you are either in retirement with lower income or working for lower compensation.
Second, consider the composition of the amount you may wish to convert.
If you opened a Traditional IRA and funded it with non-deductible contributions right before or during a significant market pull back, you may be able to convert now without generating any tax liability.[4]
Third, if you have an account with a substantial balance that you wish to convert fully, you may do that over a period of years.
While your conversion will be subject to the pro rata rule, you can choose to convert only a portion of the account to keep yourself from bumping up into the next marginal tax bracket.
If you work in a cyclical field and sometimes have years with lower income, you may wish to time your conversion to a year when you your income is lower than usual.
Lastly, it is a best practice to pay the taxes due on any conversion from a source other than the converted account.
Paying taxes from the account you convert will take dollars out of a tax-deferred vehicle which runs counter to the whole idea of tax deferral. Plan to pay the tax liability from non-IRA sources whenever possible.
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Robert W. Baird & Co. Inc. does not give tax or legal advice. Always consult with your tax advisor when considering any Roth conversion strategy.
[1] A discussion of the Backdoor Roth IRA strategy is beyond the scope of this post.
[2] $30,000 taxed at 32%. This scenario is for illustration purposes only. Your situation may differ. Consult your tax advisor.
[3] $13,500 taxed at 32%. This scenario is for illustration purposes only. Your situation may differ. Consult your tax advisor.
[4] E.g. you contributed a total of $16,500 over three years and your account is now worth $16,000 due to investment losses, your conversion would be tax free.
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