Does It Make Sense to Convert Your IRA to a Roth IRA?

5/23/23 - An updated version of this article is available here.

Converting your IRA to a Roth IRA is a tax planning strategy that may provide significant tax savings down the road. Hopefully by the end of this article, we have explained the components that go into the conversion process well enough to help you determine whether this strategy could be right for you.

Certain parts of this process can at times prove to be difficult and should be left to a financial advisor and/or tax professional.

Below, we discuss the components and rules that govern Roth IRA conversions.

Traditional IRAs

Traditional IRAs are savings vehicles that may have originated from an employer-sponsored plan, such as a 401(k), that was used to defer taxes on the amount you contributed. The money left in these accounts will continue to grow on a tax-deferred basis, which means you are only taxed on the dollars coming out. Sounds pretty good, right? Well, not so fast …

Withdrawals from these accounts are subject to ordinary income tax rates, which means all of the growth will be taxed as ordinary income.

Traditional IRAs are also subject to Required Minimum Distributions at age 70½.

Required Minimum Distributions (RMDs) in IRAs

You are required to take mandatory withdrawals from your IRAs in the year following the year you turn 70½. Failing to plan for RMDs might cause surpluses in your cash flow, which means you could pay more in taxes than you should. Moving your IRA dollars to a Roth IRA is a way to help reduce or possibly eliminate the need to take Required Minimum Distributions after you turn age 70½.

Something else to think about: Leaving IRAs to your children or grandchildren. When a child or grandchild inherits an IRA, they are required to immediately start taking RMDs. While they will be appreciative of the sudden inheritance, they may not be anticipating the larger tax bill they also just inherited. On the other hand, inherited Roth IRAs are still subject to RMDs; however, the money will be received tax-free and does not increase the taxable income of your beneficiaries.

Roth IRAs

Roth IRAs consist of after-tax contributions and do not allow for a deduction like a traditional IRA does. The major advantage of having a Roth IRA is that both distributions and investment earnings are not just tax-deferred - as with traditional IRAs - but are completely tax-free. There are income limits when contributing to a Roth IRA, but there are no income limits when converting a Traditional IRA to a Roth IRA. Amounts contributed to a Roth IRA can always be withdrawn at any time.

Roth IRAs are also not subject to Required Minimum Distributions.

5-Year Rule

Roth IRAs are subject to what is called the 5-year rule, meaning in order for your earnings from a Roth IRA to be withdrawn tax-free, they must be withdrawn after age 59½ or at least 5 years after the first contribution is made to your first Roth IRA.

Each conversion you do also has its own 5-year period governing it, with the first or oldest conversion having to be withdrawn first. In other words, after the first conversion satisfies the 5-year rule, any subsequent conversions will satisfy the rule.

Any premature distributions will be subject to a 10% penalty tax.

Pro-Rata Rule

The pro-rata rule is a common problem experienced when doing conversions and prevents taxpayers from converting solely the non-deductible portion of a Traditional IRA to a Roth IRA. The rule stipulates that the portion of the conversion that is taxable is determined by dividing the non-deductible contributions by the total IRA balances of all Traditional IRAs combined.

Backdoor Contributions

If your income exceeds the contribution limits to a Roth IRA, you may be eligible for a strategy called a “backdoor contribution.” This involves making a non-deductible IRA contribution and then immediately converting it to your Roth IRA.

This strategy is best executed when there are no other existing IRAs. This is a difficult strategy and should be done with the assistance of your financial advisor and/or tax professional.

Timing Your Conversions

In years where your income is low, you can take advantage of potentially being in a lower tax bracket and do Roth conversions. Generally speaking, deductions are negligible in lower tax brackets, and it may make sense to make Roth contributions and/or utilize Roth conversion strategies. Another important component of timing is having the cash available to pay the taxes on a conversion.

It is important to also be aware of the adjusted gross income (AGI) thresholds for the Medicare Part B & D surcharge, which can increase monthly premiums if your income exceeds these limits.

How to Convert your IRA to a Roth IRA

Before 2010, Roth conversions had an adjusted gross income limitation of $100,000. The good news is that this rule was permanently eliminated.

Generally, conversions to a Roth IRA should be made up to the limit of your current marginal tax bracket, so you don’t get bumped into the next tax bracket. Roth conversions and non-deductible contributions to a Traditional IRA are tracked on Form 8606.

You can make a direct transfer within the financial institution where your Traditional IRA is held, or you can complete a 60-day rollover, where you can physically receive a check made payable to you and then deposit the amount in a Roth IRA. You have 60 days to complete this rollover or else the amount of the funds withdrawn, minus any non-deductible contributions, will be subject to taxation.

Changes Under New 2018 Tax Law (TCJA)

Prior to 2018, 2017 conversions could be reversed by transferring the converted funds back into a Traditional IRA before the due date of the tax return, in a process called “recharacterizing”.

Due to the new favorable lower federal tax rates and larger tax brackets, converting your Traditional IRA to a Roth IRA just got better.

Asset Location in IRAs vs. Roth IRAs

The equity/stock (growth) portion of your portfolio should be located in your Roth IRA to take advantage of tax-free growth. The fixed-income (income-generating) portion of your portfolio should be located in your IRAs to take advantage of tax-deferred growth.

How We Can Help

At Mission Wealth we will invest in you and your future so that over time – as you accumulate and grow your assets – we can help you achieve your goals and give you greater flexibility. The Emerging Wealth Solution offers the first step toward management, refinement and prioritization of your financial and investment goals. As you experience life-changing events, such as a sudden inheritance, purchase of a home, a new marriage, loss of a loved one or divorce, you may find yourself seeking a trusted advisor to provide financial security and caring advice.

Ultimately, investing for a lifetime is a long road. By avoiding mistakes and missteps early, investing regularly, and with a bit of prudent financial management, the emerging wealthy individual can be well on their way towards a productive future and retirement. Mission Wealth can chart a reasonable course of action to help an individual start down this road with the best foot forward.

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