EP 29 Roth Conversions

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Welcome back to Money Matters where I help guide you in becoming a better and more confident investor. In this episode I want to go into more detail on Roth Conversions. It's generally a good idea for most investors to consider including a Roth IRA in their overall retirement planning accounting for some tax-free income for down the road given you follow the simple rules. Plus, Roth IRAs don't have required minimum distributions or RMDs during the lifetime of the original owner, and Roth IRA assets may pass to your heirs tax-free. Anyone can convert their eligible IRA assets to a ROTH IRA regardless of their income. And while you’ll have to pay income tax on the amount converted in that given year, there are a few scenarios on how and when it may be to your advantage, but first it’s a good idea to consult with a tax advisor before deciding to do a conversion.

If you believe your tax bracket will be higher in retirement. Then a Roth conversion may be for you. If that’s the case then paying taxes today is preferable to paying the taxes years later at a higher tax bracket. Not to mention taxes could go up in the future. I find they typically don’t go down over time.

If you don’t have much tax diversification over different account types. Meaning a majority of your holdings are in tax-deferred accounts, or taxable accounts. By converting to a Roth IRA, you’ll have assets that won’t be taxed when withdrawn, potentially allowing you to better manage your tax planning during retirement.

Another reason being you have irregular income streams and lower than usual income this year. For example, you might own a business that generated a net operating loss from non-passive income. This could be the perfect opportunity to convert some funds to a Roth IRA with a relatively low tax impact. Or simply if you’re IRA account had pulled back due to market activity, and it’s been a down year. That might be a good time to make a conversion knowing you’ll be paying less tax on the depreciated assets that are being converted.

And lastly, you want to maximize your estate for your heirs. If you don’t need to tap your IRA funds during your lifetime, converting from a traditional IRA to a Roth IRA allows your savings to grow undiminished by your yearly required minimum distributions that take place at 72 years old in Traditional IRA which potentially could leave more for your heirs, who can also benefit from tax-free withdrawals during their lifetimes. Say you lived until 92 years old, well then that’s another 20 years of compounding returns that you could leave to your beneficiaries TAX FREE.

On the flip-side of this conversation. Now let’s tap into some of the reasons why converting to a Roth IRA many not be such a good idea.

For some people, sticking with a traditional IRA or other tax-deferred accounts might be a better strategy. A Roth conversion might not be the best option in the following situations: You’re nearing, or in retirement and you need your traditional IRA to cover your living expenses so you’re actively drawing on the account. In this situation your assets won’t have time to recoup from the taxes you would have to pay.

It might not be beneficial from a taxable income stand point. Say you’re currently receiving Social Security or Medicare benefits. If a Roth conversion were to increase your taxable income, then more of your Social Security benefits would be taxed and your Medicare costs would rise.

Say you don’t have money set aside to pay the tax on the conversion. Or money that’s invested in your taxable account has been invested for years and has a very low-cost basis, meaning if you were to sell those assets to pay the conversion tax, you’d have to end up paying capital gains tax on the investments sold. If you have to pay a conversion tax with IRA assets, it could take even longer to recoup the tax loss.

You plan on giving a substantial amount of your traditional IRA to charities by utilizing a Qualified Charitable Distribution (QCD) to meet your RMD requirements. If you don’t plan on using your IRA assets yourself or passing them on to heirs, then a QCD could minimize or reduce the tax impact of RMDs. In this case, converting to a Roth IRA could be counterproductive, since you wouldn’t avoid taxes as you would with just a QCD.

Now that you know some of the reasons for and against initiating a Roth conversion you might be wondering how you convert from a traditional IRA to a Roth IRA.

If you and your tax professional decide a Roth IRA conversion is right for you, you’ll need to keep a few things front of mind. When to execute the conversion. If you have a significant balance in your traditional IRA, you may want to carry out multiple Roth IRA conversions over several years. If done properly, a multiyear approach could allow you to convert a large portion of your savings to a Roth IRA while limiting the tax impact. For example, you might convert just enough to keep additional distributions from being taxed at the next higher tax bracket. Early in retirement—when your earned income drops but before RMDs kick in—can be an especially good time to implement this strategy. One issue to be mindful of is making Roth conversions when you are close (within two years) to filing for Medicare and Social Security. A Roth conversion could increase your Medicare premiums and the taxes you pay on Social Security benefits.

Then there’s how to best pay the tax bill that comes with doing a conversion.

We recommend paying with cash from outside your IRA for a couple of reasons: Any IRA money used to pay taxes won’t be accumulating gains tax-free for retirement, which goes against the very purpose of doing a Roth IRA conversion in the first place. If you sell appreciated assets to pay the conversion tax, capital-gains taxes could further undermine the benefits of a conversion. Plus, if you’re under 59½ and withdraw money from a tax-deferred account, you’ll incur a 10% federal penalty (state penalties may also apply). You can’t undo a Roth conversion. Under a new rule in the Tax Cuts and Jobs Act of 2017, you can no longer “re-characterize” or undo a Roth conversion. Once you convert, there’s no going back.

The decision to convert to a Roth IRA doesn’t have to be all or nothing. You may find dividing your savings between a Roth and a traditional IRA or a Roth IRA and a traditional 401(k) is the optimal solution for you. Overall, converting to a Roth IRA might give you greater flexibility in managing RMDs and potentially cut your tax bill in retirement, but be sure to consult a qualified tax advisor and financial planner before making the move.

I hope this video helps give you something to think about as you give retirement more thought. Any further questions on the matter please feel free to reach out to me directly. Thank you for watching and as always, thank you for giving your finances the attention that they deserve.