Understanding Roth Conversions

Understanding Roth Conversions

Did you know that you can reclassify money from a Traditional IRA into a Roth IRA? This reclassification is called a Roth Conversion, and this blog will help you identify whether it makes sense for you. Remember, the trade-off with a Roth IRA is that your contributions are not tax deductible (con), but your money can be invested to grow tax-free (pro).

A Roth Conversion is not the same thing as a contribution. A contribution deposits new dollars into your Roth (up to $6,000 or $7,000 max per year). A Roth Conversion is where you take money from a Traditional IRA and transfer it to a Roth IRA. Because the funds moving from the Traditional IRA are pre-tax (i.e. you received a tax write-off each year you made contributions), you will pay taxes on the amount you convert from Traditional to Roth. However, going forward, that newly converted pot of Roth money will grow tax-free and can be withdrawn tax- and penalty-free, assuming you are older than 59 1/2 and have held the Roth for at least five “tax years”.

Due to the up-front tax consequences, Roth Conversions might not be a good idea for you. Let’s take a look at when a conversion makes sense and when it doesn’t

A Roth Conversion might be a good idea if…

  • You want to avoid or lower future RMDs (Required Minimum Distributions). The IRS forces you take withdrawals from your Traditional IRAs starting at age 72. RMDs are taxed as income regardless of whether you need the money or not. RMD rules do not apply to Roth IRAs.
  • You are in a low tax bracket in a particular year (ex: you recently lost your job or are planning to retire).
  • You are in a lower tax bracket now than you think you will be in retirement.
  • Investments in your Traditional IRA have lost value and you want to convert assets to a Roth while the value is artificially low (i.e. your tax bill will be smaller due to decreases in account value).

A Roth Conversion might not be for you if…

  • You don’t have cash to cover the extra tax caused by the conversion. Technically, you can direct your financial institution to withhold taxes from the Roth Conversion, but this means you are using your IRA funds to pay the tax. In this instance, you have less funds available for tax-free growth in the Roth.
  • You are in a higher tax bracket now than you think you will be in retirement.
  • Your IRA assets are going solely to charity when you die. Because nonprofits typically don’t pay tax on IRA assets, there’s no difference whether the organization is gifted a Traditional IRA or a Roth IRA.
  • Your beneficiary’s tax bracket is lower than yours. In other words, if you don’t plan on taking funds from your Traditional IRA during your lifetime, it’s more beneficial for your heirs to inherit the account and pay the tax because their tax liability will be smaller.
  • You think you will need the money within five “tax years”. The IRS imposes a five-year waiting period before you can withdraw funds related to the Roth Conversion tax- and penalty-free. The penalty is 10% and applies to the entire withdrawal and income taxes owed on the earnings.
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Scenario

Let’s assume that Bob and Jane are both 64 years old and that they retired on January 1st, 2021. Jane has a $60,000 annual pension from her previous employer that will support their lifestyle. To fund their retirement, they have a joint investment account worth $1,000,000. Bob also has $2,500,000 in a Traditional IRA. They are planning to claim Social Security at 70. When Bob turns 72, his Traditional IRA is subject to disburse Required Minimum Distributions, which are taxed as ordinary income. Because Bob and Jane are not working and are currently not receiving Social Security, their income bracket will be artificially low for the next six years. In this instance, a Roth Conversion might make sense. By converting portions of Bob’s IRA every year while their income is low, they can lower Bob’s future RMDs while also repositioning assets into a tax-free bucket.

2021 tax brackets

In this example, we will calculate the amount we can convert to keep them in the 12% tax bracket or lower.
First, we will determine Bob and Jane’s taxable income for the year before we make any Roth Conversions. Using Jane’s pension income of $60,000, subtract the Married Filing Jointly standard deduction of $25,100. This leaves us with a taxable income of $34,900. Then, use the outer range of the 12% bracket and subtract their current taxable income to determine their “wiggle room” in the 12% bracket.

roth conversion example

It’s important to note that if you cross over into the next tax bracket (22% in this case), only the marginal dollars will be subject to that higher bracket.

Implementation

If you only have a Traditional IRA, the first step is to open a new Roth IRA. The account can be with the same custodian or a different one, but it will likely be easier if you have one custodian for your accounts. The next step is to initiate a direct transfer of money from the Traditional IRA into your Roth IRA with the custodian. You may be able to do this online, by filling out a transfer form, or by calling your custodian. You can transfer cash or any eligible securities (i.e. stocks, mutual funds, or ETFs). At that point, you will need confirm the amount of tax to withhold from the transfer. To maximize the value of a Roth Conversion, you should not have any taxes withheld. This means that you will pay the extra tax out-of-pocket when you file your taxes the following year.

Tax Forms

If you elect to make a Roth Conversion, you will receive two tax forms from your custodian. Make sure to hold on to these forms or pass them along to your tax accountant.

  • Form 1099-R: shows how much money was distributed from your IRA
  • Form 5498: this form is sent from the institution that receives the converted Roth assets and is for informational purposes only

Roth Conversions can be a powerful way to boost your retirement plan and decrease your tax liability. However, these conversions are not an appropriate strategy for everyone. Due to the complex nature of Roth Conversions, we recommend coordinating with a financial advisor and tax professional to fully understand how a Roth Conversion will affect your financial situation.

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