Roth IRAs may be fantastic financial planning and investment vehicles for many reasons. Specifically, their tax-deferred growth and tax-free income features make them particularly attractive to savers of all ages and incomes.
Unfortunately Roth IRAs were not always a readily available option for everyone. In fact, the rules for contributing to a Roth IRA were more stringent in the past than they are today.
For example, there was no provision that allowed Roth 401(k) contributions before 2006. In addition, Roth conversions were limited to people who had an adjusted gross income less than $100,000 until 2010. The chief method for contributing to a Roth IRA was with income from earnings and even this was limited by how much the person made.
Fortunately, the rules for Roth conversion have changed. Since 2010, there has been no limit on adjusted gross income, so those at any income level can convert traditional IRA money into a Roth IRA.
What Is a Roth Conversion and Why Should You Consider It?
The short answer is that you convert traditional IRA dollars to Roth IRA dollars.
In the year of the conversion, you claim the converted amount on your tax return for that calendar year and you are responsible for paying the requisite taxes. However, all future qualified distributions will be tax-free.
A Roth conversion may be particularly attractive for several reasons, including:
- Roth IRA dollars grow tax-deferred and distributions are tax-free.
- Roth IRAs have no required minimum distribution (RMD).
- Roth IRAs remain tax-free upon inheritance.
These are not specifically tied to Roth conversion. They are simply great features of any Roth IRA.
Roth conversion is often used as part of a more complicated financial plan that may include the following life events:
- Taking advantage of income dips due to a career/job change – If your income is low in one year because of a change of income or a loss of job, the time may be ripe to convert IRA dollars into Roth IRA dollars at little or no tax expense
- Social Security income planning in retirement – Distributions from Roth IRAs are not included as income on your tax return. Because the amount of taxable Social Security income is based on your modified adjusted gross income, which includes income from traditional IRAs, a Roth IRA may be better.
- Taking advantage of income dips during post-retirement, pre-RMD years – It’s not uncommon for retirees to spend several years in retirement prior to RMDs. During these years, it’s possible that their income is low, which makes it a great time to explore the possibility of converting traditional dollars into Roth dollars.
- Lowering your overall RMD – Many savers choose to take a tax deduction when dollars are earned by contributing to a traditional IRA or 401(k). This often leads to having so much money in a traditional IRA that the RMDs exceed the income you need, potentially forcing distributions into a higher tax bracket. Roth conversions can lower the RMD because Roth dollars are not subject to the same RMD rules as traditional IRAs.
- Estate and wealth transfer planning – Sometimes it’s not about taxes now, it’s about taxes later. If someone inherits an IRA, they will be taxed on the distributions. If they inherit a Roth, they will not be. All else being equal, Roth IRAs may be one the best thing to inherit. This can be done via a Roth conversion strategy.
While many of these features may seem particularly attractive, it does not mean that a Roth conversion always makes sense.
To decide on whether or not it makes sense, you need to fully understand the tax impact of conversion versus the long-term tax impact of not converting. You should also consider other income sources and income needs. And, finally, you should consider your short- and long-term wealth transfer plans.
All of these considerations, along with the typical questions about age, risk tolerance, and risk capacity, will help to determine whether a Roth conversion makes sense for you.
How a Roth Conversion Works
Completing a Roth conversion is relatively simple.
Option one is to make a withdrawal from an IRA. As long as the withdrawn money is deposited into a Roth IRA within 60 days, the Roth conversion is complete; if you miss the 60-day deadline, the distribution will be taxed and penalized if you are under the age of 59.5.
The second option is to complete a trustee-to-trustee transfer, in which the holder of the IRA never takes control of the money, or to complete a transfer with the same trustee.
The Tax Impact of a Roth Conversion
Any amount not previously taxed will be subject to income tax in the year of conversion. With a traditional IRA, the amount not previously subject to tax is typically 100% of the account balance.
However, some traditional IRAs contain after-tax dollars. This portion of the Roth conversion will be specifically exempt from income taxes.
Knowing that the dollars associated with a Roth conversion will be taxed at ordinary income tax rates, one can strategize the best method for a Roth conversion. For example, it may make sense to convert one large lump sum, say $250,000.
On the other hand, it might make sense to do a series of Roth conversions over a period of many years. Using the same $250,000 as our example, converting $50,000 a year for five years may be the best strategy.
Coming up with the right answer to this question will require a full analysis of projected tax returns, as well as the time horizon, income needs, and other factors.
The Chance to Undo It
One of my favorite features of the Roth conversion is the ability to undo it: To go back in time and say, “I want to undo what I did.” This is known as a Roth recharacterization. It may be an attractive feature in several situations:
- The stock market tanks – Imagine that you converted $250,000 into a Roth IRA and the market subsequently dips to $175,000. Upon conversion, you owe tax on $250,000 that is now worth $175,000. Not exactly a good deal. Recharacterization allows you to undo this and turn the dollars into IRA dollars again, avoiding the tax.
- You converted too much – A large factor of Roth conversions is tax planning. This planning often involves an attempt to “fill up” certain tax brackets. For example, one goal may be to fill up the 25% tax bracket. If you happen to far exceed the planning goal, you may owe considerably more in taxes than you had planned. A recharacterization may be able to fix this problem.
- You may not have the money to pay the taxes – Sometimes things do go the way you want them to, and that may mean you don’t have the money to pay the taxes due for a conversion. A recharacterization will allow you to undo this.
For those seeking to undo a Roth conversion via a recharacterization, the last day they can do so is the filing date of their tax return, including extensions.
Burst of Knowledge – An additional feature of a Roth conversion is the ability to reconvert. Say you recharcterized as above and then decide again to convert. You can do so. However, timing rules do apply. Generally you can reconvert on the later of January 1 of the following year OR 31 days after the recharacterization.
Why Do I Love Roth Conversions?
The short answer is that I think they offer a great planning tool that is often under-utilized. I think that too many people fail to adequately consider the long-term advantages of tax deferral and tax-free income. Instead, they focus on the isolated tax savings today.
I’m equally intrigued because I think that, with attention to key planning opportunities, retirees may be able to transfer dollars strategically from a traditional IRA into a Roth IRA at potentially low tax rates.
Finally, Roth IRAs can help to meet so many planning needs: estate transfer, tax-free income in retirement, tax coordination with other retirement income sources, and accessibility to contributions if necessary.
All these things make Roth IRAs attractive. And, while Roth conversions may not be for everyone, they may want to be considered as part of the right financial plan.
Tax or legal services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
None of the information in this document should be considered as tax or legal advice. You should consult your tax or legal advisor for information concerning your individual situation.
Contributions to a Roth IRA are not tax deductible and there is no mandatory distribution age. All earnings and principal are tax free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn any time without penalty (subject to some minimal conditions).
An individual retirement account (IRA) allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred (no capital gains or dividend income is taxed). Individual taxpayers are allowed to contribute 100% of compensation up to a specified maximum dollar amount to their Traditional IRA. Contributions to the Traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors. Taxes must be paid upon withdrawal of any deducted contributions plus earnings and on the earnings from your non-deducted contributions. Prior to age 59½, distributions may be taken for certain reasons without incurring a 10 percent penalty on earnings.