Roth Conversions: What You Need to Know

When opening a retirement savings account, you’re typically presented with the option of choosing between a Traditional or Roth IRA. Many investors choose a Traditional IRA by default because they rolled it over from a 401k at a previous employer, and up until only recently the only option was a Traditional 401k. Hence, it needed to roll into a Traditional IRA to avoid a taxable event. Whether you stuck with a Traditional IRA because it was your only option or for the initial tax savings, you now have the option to change your mind and opt for tax-free retirement income instead. Making this switch is called a Roth conversion. The question I frequently get asked is, "Should I consider taking advantage of this opportunity, or am I better off sticking to my current savings strategy of the Traditional IRA?"

I've developed some basic concepts to consider when making this decision:  

What Is a Roth Conversion?

In a way, it's like gender reassignment surgery, but for your retirement assets. Like the former, a Roth conversion refers to the act of waking up one day and deciding you want your Traditional IRA account to be a Roth IRA account. The reason you might do this is that a Traditional IRA account was typically and initially created using pre-tax dollars, meaning the distributions you take from a Traditional IRA account in retirement is taxable income. Investors do this because they value that immediate (same year) tax deduction. A Roth IRA, however is funded with after-tax dollars, meaning that in exchange for forgoing the immediate tax deduction, all distributions from a Roth IRA account in retirement will be tax-free (because tax has already been paid).  

Roth IRAs are appealing options for plenty of reasons, including the following:

• It does not include a required minimum distribution (RMD) age where you have to start taking distributions like a Traditional IRA.
• You can contribute to a Roth IRA your whole life, whereas a Traditional IRA cannot accept new contributions directly after age 72.
• There are some cool early withdrawal options from a Roth in case you find yourself in a financial predicament, including the ability to use a portion of assets for education for anyone in your household as well as a first home for certain qualified purchases. There are several conditions to meet for this, so you should consult me, your investment advisor or your tax professional to go over those in greater depth. 

All of these reasons means that you can continue to save and grow tax-free dollars for the remainder of your life. 

Considerations to Make Before Doing a Roth Conversion

While a Roth conversion could be a great option for some, it could be a costly mistake for others. That’s why we’ve outlined four important considerations to make before converting your Traditional IRA into a Roth account.

Consideration #1: Your Timeline to Retirement

If you’re retiring within the next few years, you may want to forego a Roth conversion. Why? Because the money you convert into a Roth IRA must stay there for a five-year holding period. If withdraws are made before the five years is up, you could be hit with a 10 percent penalty and/or additional income taxes. You simply do not have enough time to make up what is lost in the conversion.

Consideration #2: Tax Obligations

When considering a Roth conversion, you obviously should not ignore the new tax implications associated with this move. While your aim may be tax-free income in retirement, you will have to pay taxes on that income at some point. You need to be prepared to pay the taxes on this additional income, which could very well push you up into a higher tax bracket. While it’s possible to cover the difference using a portion of the distribution itself, this is typically not advised for two reasons: you’d be robbing your future retirement of income and you may be subject to a 10 percent penalty for taking the funds. 

Consideration #3: Your Future Tax Bracket

One of the main reasons an individual chooses to do a Roth conversion is for the advantage of tax-free withdrawals in retirement. With that in mind, you’ll want to take into consideration whether your tax bracket will be higher or lower in the future when you anticipate withdrawing the funds. If you believe you’ll be in a lower tax bracket come retirement, it may be worth waiting to withdraw the funds then. On the other hand, if you’ve experienced a year of interrupted or lowered income (lost a job, missed out on a bonus, etc.), you may be in a lower tax bracket now than you would when entering retirement.

Consideration #4: How Much to Convert and When

If you’re on the cusp of a higher tax bracket, but still want to do a Roth conversion, you do have the option to convert a portion at a time. By spreading the conversion across several years (as opposed to one lump sum), you can lower your yearly tax obligation. 

How to Make a Roth Conversion

The IRS offers three possible ways for an individual to convert funds from a Traditional IRA into a Roth IRA account. These methods include:

• Rollover: You are given the funds and must put the funds into a Roth IRA account within 60 days. 
• Trustee-to-trustee transfer: The institution currently housing your Traditional IRA transfers the distribution to a different institution where it'll be held in a Roth IRA.
• Same trustee transfer: The institution currently housing your Traditional IRA is able to also house your Roth IRA, and they roll the account over for you.¹

Being able to withdraw income tax-free in retirement is an appealing option for many. And it’s good to know that while you may have chosen to open a Traditional IRA years ago that you have the option to convert it at any time. Before making any moves to your retirement savings account, make sure to speak with your financial advisor first. Together, you can go over these important considerations in regards to your unique financial situation.