Financial Planning

Traditional and Roth IRAs are two powerful tax-advantaged savings vehicles. The primary difference between the two is that qualified contributions to a Traditional IRA are deducted from taxable income the year made and included in taxable income when withdrawn. On the other hand, Roth contributions are made using after-tax dollars and, along with any earnings, are withdrawn tax-free. Traditional IRAs are subject to Required Minimum Distributions beginning at age 72 while Roth IRAs are not, if the IRA owner is still living.

So, is now the right time to convert existing Traditional IRA assets to a Roth IRA by paying the income taxes on the IRA balance? If not, when is a good time to do so?

As with most financing planning topics, there is no blanket answer which fits everyone’s situations, but the following provides some key reasons why a Roth conversion may or may not be appropriate.

Factors Supporting Conversion

• Current tax rates are expected to be meaningfully lower now than in the future, due to anticipated changes in tax laws or income.
• Withdrawals from the IRA aren’t necessary to meet future spending needs, whereby reducing Required Minimum Distributions, the IRA assets can continue to grow tax-advantaged for longer.
• Taxes on the conversion will be paid using taxable assets and not IRA assets – Avoids the 10% penalty on the amount withdrawn from the IRA for taxes if under age 59 ½, and essentially is an additional after-tax contribution to the Roth IRA.
• Making a “back-door” Roth IRA contribution – if income is too high to deduct Traditional IRA contributions and to contribute directly to a Roth IRA, you can make after-tax (non-deductible) contributions to a Traditional IRA and immediately convert the amount to a Roth IRA.
• You are older and expect your estate and assets to transfer soon and your estate is over the estate tax exclusion amounts and/or you wish to limit the future income tax liability passed on to heirs.

Factors Against Conversion

• Future tax rates are expected to be approximately the same, or lower, than current tax rates.
• If the additional taxable income would trigger meaningful detrimental tax treatment of other transactions (i.e., a 3.8% Medicare Contribution tax, a higher long-term capital gains tax rate, reduced eligibility for certain tax deductions, etc.) that year which reduce the overall benefit.
• Taxes on the conversion would be paid using Traditional IRA assets, especially if under age 59½.
• You plan to make significant charitable gifts during your lifetime and/or at death – Annual Qualified Charitable Distributions and any IRA balances left to charities may avoid taxation completely.
• You have a short remaining life expectancy and it is not a priority, or is not beneficial, to reduce your gross estate and/or future taxable income for beneficiaries.

The SECURE Act of 2019 made significant changes to how IRA beneficiaries, other than spouses and certain other individuals, must withdraw any Traditional and Roth IRA balances they inherit in 2020 or later. Previously, most beneficiaries could “stretch out” inherited IRA withdrawals over their lifetimes, however, most non-spouse beneficiaries must now withdraw the entire inherited IRA balance, and pay taxes on any Traditional IRA assets, within 10 years.

Beneficiaries are not subject to the 10% early withdrawal penalty and qualifying Roth IRA withdrawals are tax free to the beneficiary. Thus, you may also want to consider the above in the context of your beneficiaries’ personal situations.

If you decide to move forward with a Roth IRA conversion, you should consider doing so in low-income years, or spreading out a conversion over multiple tax years, given that conversion amounts are tacked on to existing taxable income the year completed, and therefore are taxed at your current marginal or potentially higher tax rates.

Along these lines, income is generally lower between retirement and when Required Minimum Distributions from Traditional IRAs begin at age 72. However, the CARES Act waived all Required Minimum Distributions for 2020, making 2020 an opportune year for those already taking Required Minimum Distributions to also convert Traditional IRAs to Roth IRAs.

This information is intended as a high-level overview and does not represent a recommendation for or against any specific individual converting their Traditional IRA to a Roth IRA. We recommend individuals discuss their specific situation with their financial advisor and a qualified tax professional, especially as a Roth IRA conversion may no longer be “undone” (recharacterized) effective as of 2018, making the action permanent.

As we continue to navigate through these changes and uncertainty, it’s important to stay focused on long-term goals. If you have questions on whether you are on track, you should reach out to your financial advisor or contact us.

Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.