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Is a Roth Conversion Strategy Right For You? Thumbnail

Is a Roth Conversion Strategy Right For You?

Roth conversions are so hot right now. A conversion is simply changing the tax status on a retirement account from pre-tax to Roth (after-tax) by paying the tax due on the amount converted. I sometimes struggle with this topic because I hate the thought of anyone paying taxes until they have to, but it makes sense in certain situations for a number of reasons.   

While the Roth IRA has been in existence since 1997, a combination of factors are leading many to consider if a conversion strategy is now right for them. Including historically low individual tax rates and legislation changes affecting the Stretch IRA distribution strategy for non-spouse beneficiaries.

That’s because most of the individual tax cuts provided by The Tax Cuts and Jobs Act will sunset after 2025 (except the reduction to ACA penalty tax), and tax rates are set to revert back to the higher rates that existed previously. It’s a guess where they go from there.

Additionally, the Secure Act was passed in 2019, and with it came sweeping changes to retirement accounts, including the Stretch IRA. No longer can a non-spouse beneficiary ‘stretch’ distributions from an inherited account over their life expectancy. The rule changes mandate the account to be distributed in full in no more than 10 years. This may lead to many beneficiaries being pushed into higher tax brackets from distributions.

These are good reasons to consider a Roth IRA conversion, but there are some important considerations when deciding if a conversion is right for you.


First, why consider a Roth conversion strategy?


Most often the first reason named by people is the idea of tax-free income in the future. Rightly so, this concept is very appealing, and if you feel it’s likely for tax rates and/or your income to increase in the future, this further reinforces the idea. Withdrawals from a Roth IRA are tax-free if you meet the 5-year holding requirement and are over age 59.5.

Another popular reason is legacy planning and leaving a smaller tax bill for your heirs. We mentioned the changes to IRA distribution rules for beneficiaries, a conversion may potentially help to make a more tax-efficient transfer of wealth to your heirs and reduce the risk of them facing a potentially higher tax bill from the new distribution rules.

Other considerations include: 

  • Tax diversification or having a bucket of money pre-tax as well as after-tax to hedge against changing tax rates in the future. 
  • Required minimum distributions are not required after reaching age 72 from Roth IRA accounts 
  • Distributions may avoid Medicare surtax that applies to couples with income above $250,000.


What do you need to think about before converting to a Roth IRA?


How you will pay for the conversion. The total amount being converted is taxable as ordinary income in the year you complete the conversion, and it’s generally a bad idea to use the funds that are being converted to pay for the tax. That’s because you are taking away from the account balance that can potentially grow tax-free, and if you are under age 59.5, a 10% penalty tax will also apply on any part of the distribution not converted. It’s important to plan to have funds available to cover the extra tax liability, as we’ll touch on later, converting in chunks over a number of years is also an option.

If you need the funds within the next 5 years. Roth IRA accounts carry a 5-year holding period rule in order to receive tax-free status on withdrawals. If you’ll need to access the account prior to satisfying the 5-year rule, a conversion probably isn’t right for you.  

Which tax bracket you fall in. Will this increase your marginal tax rate? Since the conversion amount counts as ordinary income, it has the potential to move you into a higher tax bracket.  It’s important to review your projected adjusted gross income to see where you fall within the designated tax brackets and avoid moving into a higher one.

Moving. Are you planning to move to a state with higher taxes? Many people plan to move to another state in retirement, time your conversion appropriately based on your move. 

When is a good time and how should I convert to a Roth IRA ?


Of course you are able to complete a Roth IRA conversion at any time, however, there are a few strategies to consider as you work through the process.

An opportune time for some people is right after retiring but before social security and other retirement income sources kick in. This is a time period where your income and tax bracket may be at a lower point, and before RMD’s start.

Many people also look for a market downturn as an opportunity. With depressed stock prices and account values come a correspondingly smaller amount of tax due. However, this can be hard to time. The most recent stock market downturn and move back up came fast and furious in both directions.

Another popular approach is to fill up tax brackets with a strategy named ‘barbelling’. This simply means you will convert an amount that will push you to the end of your current tax bracket but not into the next higher one. This can be done over a number of years depending on how large of an account balance you are seeking to convert to a Roth IRA.

Backdoor and mega-backdoor strategies. The backdoor Roth is a strategy for people who earn too much income to contribute to a Roth IRA directly. Since there aren’t any limitations on who or how much you can convert to a Roth IRA, the strategy calls for you to contribute to an after-tax IRA and then convert the amount to Roth. However, there are some pitfalls to be aware of, including the IRS pro-rata rule.

The mega-backdoor Roth is similar, however it allows you to contribute/convert more than the backdoor strategy, an amount up to $37,500 per year (for 2020). That’s because it leverages contributions to a 401(k) plan that are then converted to Roth 401(k) or Roth IRA depending on the plan. To complete this strategy you’ll need a retirement plan that allows after-tax contributions, and your employer must allow in-service distributions or the ability to move after-tax contributions to a Roth 401(k).

Bottom Line

There is a lot to think about and consider with a Roth conversion strategy. Please reach out if you’d like to explore an approach that may be right for your situation.


*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 
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