A Roth IRA conversion is something that you may be considering now that the lowered tax rates from the Tax Cuts and Jobs Act may be increasing under the Biden administration for individuals earning $400,000 or more. Before acting quickly to convert your traditional IRA to a Roth IRA, there are many important factors that should be considered when planning a conversion. Below you will find ten key considerations to review before making the conversion.
1. Current and Future Tax Rates: Although you cannot know what the tax rates at the time of your retirement will be, the current tax system can still inform your decision-making process. As tax rates are currently low, now might be a good time to consider the conversion of a traditional IRA to a Roth IRA. If you convert now, you will pay the current tax rates on the extra income triggered by the conversion and avoid the potential for higher future rates on all post-conversion income that will be earned in your Roth IRA account. In effect, the Roth IRA conversion strategy ensures you against future tax rate increases. These increases would otherwise impact withdrawals coming from your current traditional IRA balances plus future account earnings if not converted.
However, if you expect to be paying lower tax rates or shifting into a lower tax bracket during retirement, you may be better off making the deductible traditional IRA contribution now. This is because the current deductions may be worth more to you today than tax-free withdrawals will be later.
2. Your Future Tax Bracket: Do you predict that your tax bracket, when taking withdrawals, will be no less than it is at the time of the conversion? If you answer yes, converting your traditional IRA account today while the tax rate is lower could be beneficial.
3. Consequences in the Year of Roth IRA Conversion from Additional Taxable Income: It is important to be aware that the conversion will create additional taxable income. This could create negative tax consequences due to the increase in your adjusted gross income (AGI). Some tax benefits may not be available if your income reaches certain limits, potentially created from the conversion. Some items that could be limited over certain AGI levels include child tax credits, education tax credits, adoption tax credits, interest expense deduction on student loans, medical deductions, and the ability to make certain IRA contributions.
However, the additional income generated in the year of a conversion can also be a good thing. If you have expiring tax credits or net operating losses that require additional income to take advantage of, you may want to consider the conversion.
4. Payment of the Tax Due to the Conversion Income: Are you able to pay the tax due on the Roth IRA conversion with funds outside of the IRA or qualified plan? If the tax is paid from the IRA’s funds, the funds are subject to income tax and the 10% early withdrawal penalty. If you do not have the cash outside of the fund to pay the taxes, the conversion may not be appropriate for you.
5. Length of Time Funds are Left in Roth IRA: If there is no need to withdraw funds from the Roth IRA for at least 15-20 years, a conversion could be beneficial. This would give time for the funds to grow tax-free. Also, the conversion may benefit the wealthy taxpayer who plans on leaving a large IRA balance to their beneficiaries. A Roth IRA is not subject to the pre-death required minimum distribution rules, so the funds can continue to accumulate without a tax consequence for beneficiaries.
6. Benefit of a Roth IRA in Retirement: Owning a Roth IRA will reduce future AGI as it is not taxable upon withdrawal. This can be advantageous to items sensitive to AGI thresholds such as social security benefit taxability and medical expense deductions.
7. College Students: Taxpayers who are college students or have dependents in college who are applying for financial aid may experience negative ramifications due to the additional income in the year of a Roth IRA conversion. Even though retirement assets are not included in the FAFSA, income is and could possibly reduce the financial aid offered.
8. Conversion Amount: One option you have with a Roth IRA conversion is to convert some, but not all, of the traditional IRA in a tax year. Depending on your financial situation and the value of your traditional IRA account, this strategy can help to avoid moving you into the highest tax bracket with the additional income generated by the conversion. This can be accomplished by converting the entire account over multiple years, though tax planning is needed.
9. Monitor the Pre-conversion Investment: If you expect your traditional IRA investment to grow soon, you may want to convert your investment now when it has a lower value. You will pay tax on the lower amount and the growth will be tax-free. Another opportunity available, if your existing IRA has suffered a recent loss, is to complete the Roth IRA conversion now while the value is low. That way the taxes paid will be lower before the IRA value rebounds and the growth will be tax-free once it is converted.
10. Method, Timing, and Plans: You have 60 days to complete a conversion. To avoid any complications, a direct trustee-to-trustee transfer from one financial institution to another should be the method used to complete the conversion. In addition to converting traditional IRAs, you can also convert employer-sponsored plans including 401k or 403b accounts.
Now that you have reviewed these considerations, you may be interested in learning more about the differences between traditional IRAs and Roth IRAs. If you choose a Roth IRA conversion, it is important to keep in mind that the conversion is taxable in the year that it is completed. Also, if you convert a post-tax traditional IRA into a Roth IRA, only the earnings are taxable.
If you have questions on completing a Roth IRA conversion based on your financial situation or need help completing one, please contact an Untracht Early Advisor.