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Roth IRA Conversions: Everything You Need to Know on this Tax-Efficient Strategy

Roth IRA Conversions: Everything You Need to Know on this Tax-Efficient Strategy

June 01, 2022

A question we often hear is: Should I do a Roth IRA conversion? A Roth IRA conversion can be a powerful tool toward lowering your taxes over a long period of time, but the answer to whether it is suitable for you depends on a very individual-specific analysis. There has been much popular press on the virtues of doing a Roth IRA conversion, but they often overlook some of the critical factors in determining whether it is a good decision for you. Let’s start with some basics and then look at those factors.

What is a Roth IRA?

A traditional IRA, SEP, SIMPLE IRA, or an employer-sponsored retirement plan like a 401(k) or 403(b) allows you to contribute money on a before-tax basis (the contribution is deducted from your income before income taxes are calculated) and provides tax-deferred growth on the investments in the account. Taxes are due on distributions from those accounts when taken at the then-current tax rates. Roth IRAs were created in 1997 as an alternative to those traditional tax-deferred savings plans. The key distinction is the tax treatment. With Roth IRAs, the contribution is on an after-tax basis (there is no tax deduction for the contribution), and distributions of the growth are tax-free, provided you are at least age 59½ and at least five years have passed since you contributed to any Roth IRA, either by contribution or through a Roth conversion. Other important distinctions are that required minimum distribution (RMD) rules do not apply to Roth IRAs during the IRA owner’s lifetime, and assets remaining in the Roth IRA upon death can be passed on tax-free to your beneficiaries (with limited exceptions).

What is a Roth IRA conversion?

A Roth IRA conversion is the act of transferring assets from a traditional IRA, SEP, SIMPLE IRA, or an employer-sponsored retirement plan like a 401(k) or 403(b) to a Roth IRA. There is no dollar limit on the amount you can convert or the amount of times you can convert. Contrast that to the annual Roth IRA contribution limit based on earnings, which is $6,000 ($7,000 if you are at least 50 years old) in 2022.

What is the tax impact of a Roth IRA conversion?

When a Roth IRA conversion is completed, your before-tax contributions and earnings (typically the entire converted amount) are included in your taxable income at ordinary income tax rates in the year of the conversion. No penalties apply. When converting, you are trading off being taxed today on the converted amount in exchange for not being taxed on the amount as it may grow in the future when distributed.

Factors to consider

Income Tax Rates – Understanding what tax bracket you will likely be in when you plan to take distributions is critical. If you expect the tax rate you will pay in retirement will be the same or higher than the rate in the year of conversion, then converting may be a good idea. The current tax rates are set to expire in 2025 and revert back to the higher tax rates from 2017 unless Congress takes action. Nevertheless, most retirees will be in a lower tax bracket than when they were working.

Paying the Taxes – If you need to pay the taxes on the conversion using money from the same account, it will negatively impact the decision. We typically advise avoiding this strategy if you must use retirement savings to pay the taxes.

Time Horizon – It is typically better to convert when you are younger because the longer you leave your assets in your IRA without withdrawing them, the more time you have for potential tax-free growth. Further, if your IRA funds can be left alone during your lifetime, it could be beneficial to allow your savings to grow untouched by RMDs, leaving your family to benefit from tax-free withdrawals.

Inconsistent Income – Converting during a year when your income is lower than usual could be advantageous because, as discussed above, you will only be paying income tax on the conversion at your current tax rate.

Risk Profile / Expected Rate of Return – Your comfort with risk and the corresponding rate of return from your investment decisions will influence how quickly your investment earnings can make up for any taxes you'll be required to pay if you convert.

Rule Changes – It is possible for Congress to change the rules on Roth IRAs. Rules shortening the distribution period for Roth IRA beneficiaries were recently passed, and there have been proposals to limit Roth conversions for high-income earners. While you should make a decision based on the current rules, it is possible that they change over time.

When Should I Act?

If a Roth IRA conversion is appropriate for you, know that you can apply this strategy any time of the year. While typically, we recommend waiting until later in the year when more is known about your income and tax situation for the year, using periods of market weakness, whenever they may occur, can take advantage of temporarily depressed account values by locking in taxable income at lower amounts.

In summary, Roth IRA conversions can be strategically used to save taxes on future retirement income, serve as an estate planning tool to pass on tax-free assets to beneficiaries, and act as a tax-diversification tool for your investment accounts. Whether a Roth IRA conversion is right for you is heavily dependent on an individual analysis of a variety of factors and should not be done without the review by a financial advisor who understands your tax situation. At DKS Financial Strategies, we have the expertise to help you consider a Roth IRA conversion and apply the rules to your tax situation to make the best decision for you. If you have further questions, we encourage you to contact our team for a complimentary consultation.