Should You Convert to a Roth?

Should you convert to a Roth? It might be worth consideration if you have been saving for retirement in a traditional IRA and/or an employer retirement plan (traditional retirement accounts, or TRAs).

As you may know, when it’s time to take the money out of your TRA, you will owe tax on the amount you withdraw (called a “distribution”). So when you think of the balance in your TRAs, give that number a haircut of 10% – 40% (under current tax rates) that will be sent to Uncle Sam.

Further, when you reach age 72, whether you need money or not, you will be required to take an IRS-calculated required minimum distribution (RMD). The RMD income can push you into the next tax bracket or, more commonly, into a higher bracket for Medicare premium surcharges. Surcharges mean you could pay more for Medicare (up to a few hundred dollars a month) in 2 years due to showing more income from your RMDs this year.

Finally, if you are married and leave TRAs to your spouse, he or she must eventually take RMDs. If he or she will be filing as single, there is a greater likelihood the RMD will increase income tax brackets and/or Medicare premiums.

Roth IRA Advantages

Roth’s have several advantages over traditional retirement accounts (TRAs).

1) When you think of the balance in a Roth IRA, there is no tax haircut. Money in a Roth grows tax-free forever. (Your heirs will have to withdraw the Roth money if you don’t, but they won’t owe tax then, either.) That’s a bigger balance to spend on world cruises, grandchildren, or a Winnebago.

2) Roths have no RMDs. So they might save you from the Medicare premium surcharge.

3) If you are married and die before your spouse, your spouse will not have to take RMDs either.

4) If you have a trust, it may be much more beneficial to leave a Roth to the trust than a traditional retirement account. Ask your CPA or tax attorney.

What’s the Catch?

What’s the catch? The amount of traditional retirement money that you convert to a Roth gets taxed as income in the year you make the conversion. If you convert $100,000, that’s $100,000 added to your income.

So if you are still working, and you convert some or all of your retirement money to a Roth, you will be paying tax on the converted amount at today’s tax rates, hoping/betting that the growth in the Roth will make the extra tax bite today worthwhile.

For the hope/bet to have the best chance to work, a few things help:

– You don’t expect to be in a much lower tax bracket after you quit working, otherwise you could wait and pay less tax on the conversion.

– You don’t expect to need the money in the Roth for many years, so it has time to grow.

– You are ok taking more risk with money in the Roth, because it helps to juice the tax-free growth for which you are aiming.

– You can pay the tax bill out of non-retirement money, otherwise you might have to take an even larger distribution, which then creates higher income and even higher tax.

Have a Strategy

Because of the tax hit, one popular strategy is to wait to convert until you quit working, or otherwise experience a big drop in income, and take advantage of the lower-income year(s). The amount to convert is then carefully calculated each year to keep you out of higher tax brackets for both income taxes and Medicare.

This strategy works especially well if you can also delay taking Social Security and live off of already-taxed savings or investments. You may have a couple to several years where small incremental amounts are used to fill up a relatively low bracket. Over that time it’s possible to build up a nice-sized conversion amount in a Roth.

When NOT to Convert

Converting to a Roth may not be the best strategy if any of the following are true for you:

·        You have kids in or going to college over the next 2 to 6 years. The increased income from the conversion (beginning from 2 years prior to enrollment) will possibly increase the amount on the FAFSA (Federal student aid application) you would be expected to contribute toward tuition.

·        You plan on donating most or all of your RMDs to charity. You can do this tax-free anyway by making a Qualified Charitable Distribution (QCD) from IRAs (but not employer retirement plans) beginning at age 70 1/2. You can also count your QCD towards your RMD after age 72. No sense paying tax on the conversion when you’re going to do QCDs.

·        You expect to have high medical and/or long-term care expenses. These will offset the tax on your TRA distributions too. Like QCDs, there’s no sense paying tax on the conversion if you will have high deductions to offset future distributions.

Getting Help

Getting help to convert to a Roth is usually a good idea. The easiest system is to have a Roth at the same firm where you have a TRA. Usually you can make the conversion by doing a simple transfer between the two accounts. Find out how the firm will report the distribution and conversion on your tax records. When you have more than one firm involved, get detailed information from each firm about how to make the transfer show up on their tax records properly.

The next part involves paying the tax on the conversion. Firms may ask about withholding for taxes – this can get tricky to calculate, but in general, as mentioned above, you would want “0” withheld and then submit an estimated amount from your non-retirement funds as soon as possible.

Due to the large tax consequences typically involved with Roth conversions, it’s best to consult with a CPA, tax attorney, and/or CFP™ for more detailed advice. In some cases, the future savings and flexibility a Roth affords may be well worth some extra effort and expense today.

Holly Donaldson

Holly Donaldson, CFP® runs an hourly and fee-for-service financial planning practice virtually from her Tampa Bay, Florida office. She also works with clients throughout the U.S. (except Texas) interested in retirement and tax planning advice without product sales or investment management. Holly is the author of The Mindful Money Mentality: How to Find Balance in Your Financial Future (Porchview Publishing, 2013) and publisher of the award-winning monthly e-letter, "The View From the Porch."

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