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The Roth Conversion – Should you Pay Tax Now or Later? Thumbnail

The Roth Conversion – Should you Pay Tax Now or Later?

Retirement Planning

The fastest way to get money into a Roth IRA is to move some of your traditional IRA money into your Roth IRA.   This is called a Roth conversion and it comes with a price tag.  When you move money from your traditional IRA to your Roth IRA, income tax on the amount transferred is due now.   

Why Consider a Roth Conversion?

  • Money in a Roth IRA grows tax free.  
  • There is no required minimum distribution (RMD) for the owner of a Roth IRA who is over age 73.   Converting some of your traditional IRA to a Roth will reduce your future RMDs on the traditional IRA.
  • A Roth IRA is a tax-favored account to pass on to your heirs.  Non-spouse heirs generally must distribute all of the Roth IRA funds during the ten year period following the death of the owner, but they receive those funds tax free.  

How do you Make a Roth Conversion?

  • You need to complete some paperwork for your IRA custodian, and your advisor can help with this.
  • You can move shares of a stock or a mutual fund from your IRA to the Roth.  You do not have to sell shares to make the conversion.  
  • There is no age limit.  You cannot be too old or too young to do a Roth conversion.
  • You do not have to be working to do a Roth conversion.  You can even do this in retirement.  That could be advantageous because your taxable income may be lower.
  • There is no income cap on a Roth conversion.
  • You do not have to convert the entire IRA at one time.  You can do partial conversions.  In fact, a structured plan to convert a portion of your IRA annually over several years is likely to reduce your overall tax liability.
  • The conversion must be completed by December 31 of the year you want to pay the income tax.   There is no provision to complete a conversion after the close of a tax year.

What are the Disadvantages of a Roth Conversion?

  • The entire amount you transfer from a traditional IRA to a Roth IRA is taxable as ordinary income on your federal and state income tax returns in the year transferred.
  • This taxable distribution is added to your other income for the year and could push you into a higher tax bracket.  In addition to the tax bracket, there are other taxes that may be triggered depending upon your income.  It is important to discuss a Roth conversion with your financial advisor or accountant before making a decision so you can quantify the impact on your tax return and be prepared to pay the tax.
  • It is best to pay the tax due from money other than the IRA itself.  We do not recommend withholding taxes from the converted amount because it reduces the funds available to grow tax free.  It defeats the purpose of converting traditional dollars to Roth dollars.  If you are under age 59 ½ when you do a conversion, any amount withdrawn from the IRA to pay the income tax generates a 10% early withdrawal penalty.  Pay the tax by increasing the withholding on your paycheck or paying estimated taxes.  Use money outside of the IRA.  
  • Recharacterization is no longer an option.  Roth Conversions are permanent. Under the Tax Cuts and Jobs Act of 2017, any Roth conversion after January 1, 2018, no longer has the option of recharacterizing back to the traditional IRA.  Prior to 2018 a taxpayer had until October 15 of the next tax year to undo the conversion if you change your mind or the taxes became too prohibitive.  That is no longer possible, so do all your homework, seek professional guidance and be certain you want to convert because you cannot change your mind.

Tax Strategies to Consider

  • Be aware of your tax bracket.  Plan ahead and convert an amount that will not send you into a higher tax bracket.
  • Convert to a Roth in a year of a stock market decline so you can minimize the taxable event.   Or, pick stocks or funds that have declined in price.  Transfer those specific shares so you can move more shares at the lower price.
  • Target a year when your income is lower or you have unusual tax deductions available.
  • Stage conversions over several years rather than all at once to control your taxes.  

Conclusion

Building a Roth IRA is a good long term plan.  You will have to pay the tax at some point, so converting to a Roth and paying the tax now could be a good trade off in exchange for years of tax free growth.    Lower required minimum distributions on your traditional IRA in retirement is an added bonus.  

Every situation is different and there is no one-size fits all answer.  You must consider your own goals, objectives and tax picture.  

Don’t do this one alone.   Consult a tax planner so you know in advance how much you will owe in taxes.  The rule of thumb is, if you think you will be in a higher tax bracket in the future, convert traditional IRAs to a Roth IRA now.  It’s all about the taxes.

If you have questions and would like to see how a Roth Conversion might benefit you, call us at 540-772-4545.  

Written by Connie C. Guelich, CFP, AEP, CLU, ChFC. This represents our views at the time of this writing, and it is subject to change. It is not intended to be personal investment advice. If you would like to discuss your own account, please don’t hesitate to call us.