ToYourWealth: To Roth or Not to Roth?

If Roth IRAs had been around during Shakespeare’s time, I’m sure he would have penned “to Roth or not to Roth?” Alas, Roth IRAs have only been around since 1998 (thanks to Senator Roth – https://www.investopedia.com/history-roth-iras-5220565) but this is still one of the more frequent questions we receive about which type of account to use for retirement savings. There are several methods for getting money into a Roth in the form of CONTRIBUTIONS or CONVERSIONS.

For the sake of brevity, this article is only focusing on Roth IRA conversions. Roth contributions have their own set of rules including earned income requirements, gross income limits and maximum contribution limitations. Fortunately, Roth IRA conversions don’t have these particular constraints but they do have a variety of other factors to consider.

Before digging into the details, let’s back up to understand why a Roth IRA is worthwhile to consider. It’s all about income taxes! Money inside a Roth IRA accumulates without having to pay taxes on the growth or dividends/interest each year. In addition, subject to a few important restrictions, when you withdraw the money, the money is tax-free. Ideally, you don’t withdraw any of the money for at least five years depending on your age. Not only is the money you originally put into the Roth tax-free but so are ALL the future growth and earnings!

Sound too good to be true? Well, the major disadvantage is you have to pay income tax upfront on the money converted to the Roth. In addition, Roth conversions typically come from a Traditional IRA so if you don’t already have a retirement account, you may not be able to use this strategy.

Why would you want to pay income taxes early on a retirement account? First, if you think you might pay higher income taxes in the future then a Roth IRA conversion now can be worth the pain to avoid even greater pain in the future. Just like we diversify among stocks and bonds, it’s worth diversifying your retirement accounts between different tax treatment of withdrawals.

Second, if you might need to make a larger withdrawal from your Traditional IRA in the future, it could potentially be taxed at a higher rate due to the different tax brackets. Converting smaller amounts in anticipation of the larger withdrawal (whether it’s a planned or unexpected expense) will lower the overall tax rate on the withdrawal.

Finally, another reason to pay taxes earlier using a Roth conversion would be after a significant decline in the stock market when prices are lower. Since the future growth is tax-free, converting assets that are expected to recover can enhance the future tax savings. Regardless of recent stock market performance, it’s usually worth considering using investments with higher expected returns for the Roth conversion to further enhance the tax-free growth.

What are some other considerations before doing a Roth IRA conversion? As much as I like Roth conversions, they’re not appropriate in all situations. For example, if you expect to be a in lower tax bracket in the future, it’s less likely to be beneficial to complete a Roth conversion now. In addition, each of these situations require special consideration:

• If you’re covered by a Marketplace health insurance plan through the Affordable Care Act and eligible for the Premium Tax Credit, a Roth conversion could significantly reduce the credit.
• If you’re covered by Medicare with relatively higher income already, you could be subject to the Income-Related Monthly Adjustment Amount (IRMAA) which is also based on your total income including amounts converted to a Roth IRA.
• If you’re collecting Social Security, the additional income from a Roth conversion could increase the amount of Social Security subject to income taxes. Conversely, if you haven’t started Social Security yet, you may be able to convert more to a Roth in the meantime.
• If you have capital gains income which will be taxed at the 0% at rate, amounts converted to a Roth IRA from your Traditional IRA could push some or all of the capital gains into a higher tax bracket.
• If you have after-tax contributions in your Traditional IRA, additional planning is required if you plan to use “back-door” Roth strategies to assure the strategy works as intended.
• If you’re required to take withdrawals from your Traditional IRA (typically age 73 or older), the required distribution amount cannot be converted to a Roth. However, you could convert amounts above the required withdrawal. An even better strategy might be to donate the required distribution to charity via a Qualified Charitable Distribution to avoid paying income taxes on that amount which leaves more room in your tax bracket to convert to a Roth IRA.
• If you have an Inherited or Beneficiary IRA, these accounts cannot be converted to a Roth IRA, regardless of whether there’s a required distribution or not.

The mechanics of completing the Roth conversion including how to report on your tax return which requires a separate tax form (Form 8606) are beyond the scope of this article. It’s also important to know how you’ll pay the income taxes on the conversion before proceeding. Ideally, you’ll pay from non-retirement account sources but if you’re over age 59.5, you could potentially have additional taxes withheld from your Traditional IRA without penalty.

There’s a lot to consider when it comes to one of the best tax planning tools available. I’ve tried to summarize the major points but each person’s situation can be different. As a result, I recommend discussing further with your tax advisor (including models of different Roth conversion amounts). It’s one thing to understand the concept, it’s being able to apply it that will actually save you money!