INTRODUCTION

A Roth Conversion refers to the process of transferring a portion of an existing traditional IRA into a Roth IRA. The focus of this article is to discuss certain scenarios which may increase the advantages of initiating a Roth Conversion.

This article presumes the reader is familiar with the definitions of traditional and Roth IRAs, and the rules related to income limits, contribution limits, qualified distributions, Required Minimum Distributions (RMDs) and penalties for these IRAs. Since every client’s situation is unique and Roth Conversions may impact income tax owed, social security benefits, Medicare premiums, and access to the converted funds, customized analysis with the help of a financial and tax professional is strongly recommended to help avoid making costly mistakes.

ROTH CONVERSIONS – BACKGROUND INFORMATION

Let us start with a summary of the key taxation differences between traditional IRAs and Roth IRAs:

A traditional IRA is funded with pretax contributions (i.e., the investor is allowed to deduct the amount contributed into the traditional IRA from their taxable income for the year in which the traditional IRA contribution is made). Income taxes on the contributions and related earnings are deferred until the IRA owner takes distributions from the IRA, at which point the entire distribution is taxed as ordinary income.

In contrast, a Roth IRA is funded with post-tax contributions (i.e., the investor has already paid income taxes on the contributions to the Roth IRA). There is no further income tax owed on the contributions and related earnings when qualified distributions are taken from the Roth IRA.

HOW A ROTH CONVERSION IS EXECUTED

The IRS defines three techniques to execute a Roth Conversion:

A rollover, in which you take a distribution from your traditional IRA in the form of a check and then deposit the full distribution amount in a Roth IRA account within 60 days.
A trustee-to-trustee transfer, in which you direct the financial institution that holds your traditional IRA to transfer the money directly to your Roth IRA account at another financial institution.
A same-trustee transfer, in which you direct the financial institution that holds your traditional IRA to transfer the money into a Roth IRA established at that same institution.

The two transfer options listed above are typically recommended, as they eliminate the risk of an incurred penalty in the case that the distribution from the traditional IRA is not deposited into the Roth IRA within the required 60 days.

IMPORTANT TAX FACTOR TO CONSIDER: the amount of untaxed assets in the traditional IRA that are converted to a Roth IRA will be taxed as ordinary income for the year that the conversion is made.

KEY MOTIVATION BEHIND MAKING A ROTH CONVERSION

Similar to the analysis that leads investors to decide on whether to make ongoing contributions to traditional IRAs or Roth IRAs, a key factor in deciding to convert traditional IRA assets to Roth IRA assets is the expectation that the IRA owner’s income tax rate will be higher when they plan to take distributions from the IRA than their current income tax rate.

Another factor that may prompt a Roth conversion is estate planning. A Roth Conversion allows the current IRA owner to let the converted assets grow tax-free through their lifetime and then continue to grow tax-free after the IRA is inherited by their beneficiaries. Certain Roth IRA beneficiaries will need to withdraw all of the inherited Roth IRA funds within 10 years of the original Roth IRA owner’s death, but these distributions will be tax-free and thus, the original IRA owner avoids passing on what may be a significant tax burden to their heirs.

OPPORTUNE TIMES TO MAKE A ROTH CONVERSION

Certain scenarios improve the long-term benefits of making a Roth Conversion. It is important in all of the scenarios listed below to remember that income taxes will be owed on all previously untaxed assets that are converted from the traditional IRA to a Roth IRA, which may affect your marginal tax rate, taxation of social security benefits, Medicare premiums and overall tax burden.

Another important consideration is that you are allowed to convert a portion of your traditional IRA assets to a Roth IRA. Thus, you can develop a plan that schedules conversions over multiple years, at varying conversion amounts, to limit your tax impact.

SCENARIO 1 – YOU ANTICIPATE A CHANGE IN INCOME TAX BRACKETS

The 2017 Tax Cuts and Jobs Act (TCJA) is set to expire at the end of 2025, which will adversely change tax brackets, marginal tax rates and the standard deduction – this will lead to a higher amount of federal income tax owed at the same taxable income amount. Or you may expect to be in a higher tax bracket after you retire due to significant RMDs or other sources of income at that time. Since, in both of these cases, your marginal tax rate is likely to be lower today than in the future, a Roth Conversion may make sense.

SCENARIO 2 – YOUR TAXABLE INCOME HAS DECLINED

Various factors may lead to a reduction in taxable income in a given year, which may lead to a lower federal income tax bracket (i.e., lower tax rate). Factors may include loss of a job, a leave of absence (often tied to the birth of a child), a career change that leads to a lower income, or significant qualified deductions that reduce your taxable income. If you are tracking to be in a lower tax bracket for a given year, making a Roth Conversion should be considered.

SCENARIO 3 – YOU ARE BETWEEN RETIREMENT AND RMD AGE

This is related to Scenario 2, but we wanted to highlight this separately. Most people will have a significant reduction in taxable income in the years between when they start retirement and when they have to start taking Required Minimum Distributions from their tax-deferred retirement accounts (such as a traditional IRA). Their taxable income will increase during this period when they start to take Social Security payments but will still be in a lower tax bracket than when they start taking RMDs. This time period is ideal for building a multi-year plan based on partial Roth Conversions, to optimize the converted amount against your tax bracket and related marginal tax rate.

SCENARIO 4 – A STOCK MARKET DECLINE

A downturn in the stock market that reduces the value of your investment portfolio in general and your traditional IRA in particular will offer an excellent opportunity to consider a Roth Conversion.

Let us start with the traditional IRA: since the value of this IRA has declined due to the stock market status, a conversion at that time allows you to convert a larger portion of your tax-deferred IRA assets to a tax-free Roth IRA, at the same income tax cost. If you are confident that the stock market will recover, the gains during the recovery period and beyond will grow tax-free.

Another factor that may make a Roth Conversion appealing during a market downturn is if you plan to sell taxable assets at a loss during this timeframe, which will reduce your taxable income and may put you in a lower income tax bracket. This would lead to a lower rate of taxation on the assets converted into the Roth IRA.

BOTTOM LINE

Roth IRAs are a valuable option for retirement and estate planning, offering greater flexibility related to distributions and the potential to reduce your tax burden. However, analysis of the pros and cons of a Roth Conversion, and the impacts it may have on Medicare expenses and income taxes, will warrant the assistance of a financial professional.

*This content was developed from sources believed to be providing accurate information. The information provided is not intended as tax or legal advice, and readers are encouraged to seek advice from their own tax or legal counsel. Neither the information presented, nor any opinion expressed, constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Eustace Advisors to provide information on a topic that may be of interest. Copyright 2024 Eustace Advisors.

REFERENCES

The articles below were referenced in preparing this information and are excellent resources to better understand this topic.

Scenarios That Favor Making Roth IRA Conversions

Scenarios That Favor Making Roth IRA Conversions

INTRODUCTION

ROTH CONVERSIONS – BACKGROUND INFORMATION

HOW A ROTH CONVERSION IS EXECUTED

KEY MOTIVATION BEHIND MAKING A ROTH CONVERSION

OPPORTUNE TIMES TO MAKE A ROTH CONVERSION

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