Is a Roth Conversion Right for You?

If the grass looks greener on the tax-free side of the retirement income fence, you may want to consider a Roth conversion.

In 2019, almost 46 million households owned Individual Retirement Accounts (IRAs), and the accounts held more than one-third of Americans’ retirement savings. Most of the money was saved in workplace retirement plans before being rolled over into IRAs, according to statistics from the Investment Company Institute. [1, 2]

When it comes to IRAs, there are two basic types of accounts: [3]

Traditional. Contributions to traditional IRAs often are made pre-tax. The money can grow and compound tax-deferred until retirement. When an individual takes a withdrawal from a traditional IRA during retirement (after age 59½), the distribution typically is taxed as ordinary income.

In addition, individuals must begin taking required minimum distributions (RMDs) at age 72, unless they reached age 70½ in 2019 or earlier. (In that case, they’re already taking RMDs.) [3]

Roth. Contributions to Roth IRAs are made with after-tax money. The money grows and compounds tax-free. When people take qualified distributions from Roth IRAs, they usually do not owe taxes on the amount withdrawn, as long as certain requirements are met.* Roth IRAs are not subject to required minimum distributions. [3]

*Roth contributions can be withdrawn at any time without penalty. Roth earnings can be withdrawn tax and penalty-free as long as a qualified distribution is taken at least five years after the year the first Roth contribution was made, at or after reached age 59½, after total disability or death, or upon meeting the requirements for a first-time home purchase.

Not everyone is eligible to open or make contributions to a Roth IRA. In 2020, people who have modified adjusted gross income equal to or greater than $139,000, if they file taxes singly, or $206,000, if they file taxes as married couples, are not eligible to contribute to a Roth IRA. [3, 4]

There is a way to get around the income restriction. A Roth conversion allows anyone, regardless of income level, to convert all or part of a traditional IRA account to a Roth account. The amount transferred from a traditional to a Roth IRA is treated as income and subject to ordinary income tax. As a result, account holders should carefully consider whether they can use non-retirement funds to pay taxes owed on the conversion. [5, 6]

Roth IRAs can be valuable legacy planning tools

Many people consider Roth IRA conversions because Roth IRAs have the potential to provide tax-free retirement income. Not everyone realizes Roth IRAs can provide tax-free income over generations. A Roth conversion can be an important part of a legacy planning strategy, especially today.

The 2017 Tax Cut and Jobs Act reduced taxes for many Americans, which made Roth conversions more attractive. Then, in 2020, the Setting Every Community Up for Retirement Enhancement (SECURE) Act eliminated a provision known as the stretch IRA, which allowed non-spouse heirs to inherit IRA accounts and stretch distributions from those accounts over their lifetimes. [7, 8]

As a result of these changes, Roth IRAs have become powerful and attractive estate planning tools that can help minimize taxes over generations. The benefits of Roth conversions may include: [3]

  • Receive tax-free income. Having a source of tax-free income can help optimize retirement and tax planning strategies.
  • Keep your assets until you need them. Roth IRAs don’t have required RMDs. This means the accounts can grow and compound until you or your heirs need income.
  • Leave more for your heirs. If your beneficiaries have high incomes, they won’t have to worry about the potential impact of inherited IRA distributions on their taxes.

Roth conversions have many potential advantages, but they are not simple transactions. Traditional IRA owners should talk with their tax professional, financial professional, and/or estate planning attorney to determine whether a conversion makes sense. Among other things, the Journal of Accountancy suggests they should consider: [6]

  • Conversion alternatives, such as making qualified charitable distributions from traditional IRAs
  • The effects of conversion income on the calculation of taxable Social Security benefits and Medicare premiums
  • The effects of the conversion income on the qualified business income deduction, if applicable
  • The phaseout of many deductions, credits, and allowances

Bear in mind, there may be a limited window for conversion, however, because the new administration plans to “raise taxes on individuals with income above $400,000, including raising individual income, capital gains, and payroll taxes,” reported the Tax Foundation. [9]

If you have questions about Roth conversions, please get in touch.