Updated for 2020. It does not always make sense to convert a traditional IRA to a Roth IRA. Deciding to convert a traditional IRA to a Roth IRA can be difficult as there are a number of assumptions that need to be made and issues to consider. Your current and estimated tax rate in the future is often a main component of the decision, but there are other issues at play. Do you have sufficient cash on hand to pay the tax currently due? What are your long-term wealth projections and legacy goals? It isn’t always advisable to convert a traditional IRA to a Roth IRA, but for some, the benefits can be significant. When planning for retirement, keep your entire financial situation in mind.
How a traditional IRA differs from a Roth IRA
To better understand why it may be advantageous to convert a traditional IRA to a Roth IRA, investors need to know the key differences between the accounts. A traditional IRA (individual retirement account) allows any person with earned income to make annual contributions within IRS limits. While the ability to make tax-deductible contributions will depend on your income and whether you’re covered by another retirement plan, those ineligible for favorable tax treatment can still contribute on an after-tax basis.
Contributions to a Roth IRA will always be made with after-tax dollars, but not everyone is able to participate. In 2019, the phase-out range for single filers will be between $122,000 - $137,000 and for married couples filing jointly $193,000 - $203,00. In 2020, the phase-out range for single filers in 2020 is between $124,000 - $139,000 and for married couples filing jointly $196,000 - $206,000.
Aside from the tax treatment of contributions and withdrawals, the next biggest difference between traditional and Roth IRAs is required minimum distributions (RMDs). The Secure Act, which was passed at the end of 2019, changed the age some retirees will need to begin distributions from non-Roth tax-deferred retirement accounts. Required minimum distributions must begin at age 70 1/2 (if you're born on or before June 30th,1949) or 72 (if born on or after July 1st 1949).
Roth IRAs are not subject to RMDs, giving retirees greater flexibility in retirement and also a way to potentially leave assets to heirs on a tax-free basis.
Considerations of converting your traditional IRA to a Roth IRA
A key consideration when contemplating converting a traditional IRA to a Roth IRA is your current and projected tax bracket, either in the near future or at retirement. Converting a traditional IRA into a Roth IRA will require you to pay federal income taxes on previously tax-deductible contributions, as well as earnings.
The tax due is dependent on your tax bracket at the time of withdrawal or conversion. Therefore, this strategy is best suited for individuals in a lower tax bracket relative to where they expect to be in the future. Keep in mind: the amount you convert will be added to your taxable income for the year, potentially pushing you into a higher tax bracket.
There is a common misconception that retirees will invariably be in a lower tax bracket than they were during working years. Although this can often be the case, some retirees with a significant portion of assets in tax-deferred accounts find themselves in a much higher tax bracket once required minimum distributions begin.
Those who have considerable wealth saved will be required to take substantial RMDs from tax-deferred accounts, which are taxed as ordinary income. Retirees typically have fewer options to reduce their taxable income as well; they are usually no longer eligible to contribute to a qualified retirement plan, IRA, HSA, and are less likely to still be paying a mortgage, eliminating the interest deduction.
Uncertainty surrounding future tax rates and potential changes to the tax code has many investors looking to convert to a Roth IRA. But if you don’t have the funds available from a non-retirement account to pay the taxes upon conversion, this is likely not a beneficial strategy, as taxes would be paid from your IRA.
The good news is that the full conversion does not have to happen at once. One traditional IRA to Roth conversion is allowed each year, regardless of income.
Why Convert a Traditional IRA to a Roth IRA?
The extent to which a Roth conversion will benefit an individual is unique to their situation. Often, a Roth will provide greater benefits to those who have significant assets in retirement. For example, those who rely on regular withdrawals for support do not gain from the ability to avoid required minimum distributions.
- No RMDs – unlike IRAs and qualified retirement plans, a Roth IRA is unique in that required minimum distributions are not required during the original account owner’s lifetime.
- Tax-efficient legacy gifts – a Roth IRA is an advantageous way to leave assets to beneficiaries, as the account will pass onto an heir income tax-free, assuming a five-year holding period has been met by the decedent. (Note one: Roth IRAs may still be subject to estate tax). (Note two: Under the Secure Act, which was passed in 2019, beneficiaries who inherit any type of retirement account from a non-spouse (e.g. a parent or relative) can no longer 'stretch' the distributions over their lifetime by taking required minimum distributions (RMDs). Instead, they will be forced to take the funds in 10 years. The change won't impact anyone who inherited a retirement account during 2019 or years prior.)
- Diversification – recall the earlier discussion on retirees facing higher income tax brackets due to RMDs. A Roth can provide needed diversification and flexibility to develop a strategy for tax-efficient withdrawals in retirement.
- Tax-free earnings – assuming age and holding period requirements are met, withdrawals will be tax-free.
Before deciding to convert a traditional IRA to a Roth, weigh whether the benefits of tax diversity in your retirement accounts is enough to compensate for the loss of tax-deferred compounding. Financial modeling can be a great tool to help evaluate the impact, so contact a financial advisor to discuss the possible benefits and considerations before making the change.
Darrow Wealth Management is a fee-only financial advisor in Boston, MA and Concord, MA. To discuss your wealth strategy, contact a Darrow Wealth Advisor today.