Converting to a Roth IRA could save you money in retirement. For some, the savings could be huge. But, for others, a Roth conversion could substantially increase your tax liability, leaving you worse off than before.

So when does a Roth conversion make sense? In this article, I’ll examine 4 scenarios in which converting your traditional IRA is a good idea, followed by 4 in which it may not be ideal.

This blog answers the following (and more):

• What is a Roth conversion?
• When could a Roth conversion be helpful?
• Is converting your traditional IRA ever a bad idea?
• What is a “backdoor” Roth conversion?

What is a Roth Conversion? 

Let’s start simple and build: A Roth conversion is made when you transfer funds from a traditional IRA, SEP IRA, or a SIMPLE IRA into a Roth retirement account. In general, only people making less than a certain amount of income are allowed to contribute to Roth IRAs. 

For individuals making more than $144,000 and married couples earning above a combined $214,000, Roth IRA contributions are off-limits. However, there are no income limits for conversions. Since 2010, the federal government has allowed individuals to convert funds from a traditional IRA (and similarly-taxed accounts like those listed above) into a Roth IRA with no income requirements.

For this reason, Roth conversions are sometimes referred to as “backdoor” Roth IRAs, since anyone of any income level can end up with a Roth IRA. For additional details on backdoor Roth IRAs, check out this article on Investopedia.

Why Convert a Traditional IRA to a Roth IRA?

The primary benefit of performing a Roth IRA conversion is that it can potentially reduce your tax liability over the long term: With a traditional IRA, your tax break comes upfront. In other words, any money you contribute (up to a certain limit) is tax deductible in the year of the contribution. 

From there, your funds will grow tax-deferred and then you pay your current tax rate upon withdrawal. On the other hand, there is no up-front tax break with Roth IRAs. Your tax break is when you withdraw your money and it’s grown tax-free. That’s when you will pay $0 in (additional) taxes.

While there’s no telling how high tax rates may eventually rise, many people estimate they’ll be paid more as time goes on. As a result, they may choose to utilize Roth IRAs as a potential hedge for their savings. After they retire, Roth IRAs will offer tax-free withdrawals.

A secondary benefit of converting to a Roth IRA is the absence of required minimum distributions (RMDs). These are forced minimum withdrawals taxpayers are required to make after reaching age 72 (unless you were 70½ in 2019) from 401k’s, Traditional IRAs, SEP IRAs, and SIMPLE IRAs.

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When Does Conversion to a Roth IRA Make Sense?

If deciding whether or not a Roth conversion is right for you isn’t your idea of fun—or if you’re worried you may make the wrong decision and cost yourself thousands of dollars—this may be the right time to schedule a meeting with a financial planner.

As a Certified Financial Planner in Brentwood, TN, here’s what I believe you should know about Roth IRA conversions and when they might make sense for you. Considering the tax implications is vital: Any funds you convert will be considered regular income in the year you convert, which can lead to a hefty tax bill.

With that said, there are multiple situations in which a Roth conversion could prove advantageous:

• Your tax bracket will be higher once you retire. If you’re estimating your income will be higher in retirement than it is now (or you expect tax rates to increase in the future), it may be wise to convert to a Roth IRA and pay at your current tax rate.
  
  
• You will have a lower-than-usual income this year. If your business has had a poor year or you are in between jobs, this could be a perfect opportunity: You could convert funds to a Roth with only a small impact on your overall tax bill.
  
  
• You lack account tax diversification. Even if you’re expecting to have a higher income in the future, you may choose to convert for the purpose of tax diversification. Similar to diversifying your portfolio’s asset allocation, many investors also choose account diversification in pursuit of optimal investments for each type of account.
  
  
• You want to maximize your estate for your heirs. Roth IRAs can grow uninhibited by RMDs (required minimum distributions; explained below) and they can be passed on to your heirs. As a result, many people choose to convert a traditional IRA to maximize their estates beyond their lifetimes.

When Does a Roth Conversion Not Make Sense?

Staying with a traditional IRA might be best for some investors’ situations. That’s because it results in their lowest tax burden. Here are a few examples where that may be the case:

• Your traditional IRA will be used to cover your monthly expenses. If you need to withdraw the savings soon anyway, your assets may not have adequate time for rebuilding after the tax liability caused by the conversion.
  
  
• You plan on donating most of your traditional IRA to charities. If you plan to make tax-free charitable distributions with the funds, converting to a Roth IRA could be counterproductive.
  
  
• You don’t have the taxable funds to cover the conversion’s tax assessment. If you would need to pay the taxes due out of your IRA’s contents, you are likely to reduce your future retirement income by proceeding.
  
  
• If the conversion increases your Medicare Premiums to an unacceptable rate. Your taxable income will increase in the year of your Roth conversion. So, if the potential savings of the conversion are offset by increasing Medicare costs, a Roth conversion should be avoided.

Should I Convert My IRA to a Roth IRA?

As noted above, a Roth conversion makes sense in a handful of situations. There are also scenarios where a conversion would cost you more than it would save. As is the case with all financial planning, there’s no one-size-fits-all approach. Every person’s life situation, financial goals, asset allocations (and locations), risk tolerances, and needs are different.

That is a lot of moving parts to manage on your own. Converting in one year vs another can make a difference of thousands of dollars (if not more) in savings. Fortunately, you don’t have to handle it all by yourself: A quality financial planner can answer questions like, “When does a Roth Conversion make sense for me?” 

To learn how to make a Roth IRA conversion and get a second opinion on if it’s the right move for you, schedule an appointment with us today. We’re happy to help you explore your financial possibilities.

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