What Are Roth Conversions?

1/12/2021 - By Chris Stennett, CFP®

WHAT IT IS

A Roth Conversion is a process of moving contributions held in a traditional IRA, 401k, or another qualified retirement plan, to a Roth IRA. Non-Roth contributions plus appreciation will be included in the individual’s taxable income in the year of conversion.

WHY

Roth IRA’s are retirement savings account that feature tax-free growth and can be withdrawn without impacting taxable income, provided the Roth IRA has been open for at least 5 years and the owner is above the age of 59 ½ years old at withdrawal. For a Roth Conversion to be considered appropriate, there should be a reasonable belief that your future tax rate will be higher than the tax rate at conversion.

WHEN ROTH CONVERSIONS MAY BE APPROPRIATE

  1. Temporary Decline in Taxable Income – It is common to see taxable income decrease for periods of time just after retirement only to rise in later years. Picture the scenario of a 65-year-old recent retiree who delays Social Security until age 70 and doesn’t withdraw from her pre-tax retirement account. Between ages 65 – 70, there may be a reduction in taxable income, moving her into a lower tax bracket. At 70 Social Security will begin and at age 72 Required Minimum Distributions will need to be taken moving this retiree into a higher tax bracket. To pre-pay the taxes on future IRA withdrawals during these first 5 years, an investor could convert some (or all) of their pre-tax balance to Roth and may still stay within the lower tax brackets before Required Minimum Distributions begin.
  2. Large Pre-Tax Account Balances – There is such a thing as too much pre-tax savings. Required Minimum Distributions are mandatory taxable withdrawals from pre-tax retirement accounts. Large IRA balances will result in large Minimum Distribution requirements, which can push some retirees into a higher tax bracket. Planning ahead using one-year or multiple-year Roth conversions, an investor can reduce pre-tax balances in early retirement in order to reduce their future RMD requirements. To assist in the planning process, projecting future IRA account balances based on historical rates of return may be done by your financial advisor. 
  3. Future Tax Rates Expected to Be Higher – Other factors beyond an investor's control can cause tax rates to go up. The current Tax Cuts and Jobs Act is set to end in 2025 which would cause tax rates to revert to (higher) pre-2018 figures. President-Elect Biden or future Administrations may make changes to the prevailing tax code. Additionally, investors should consider the likelihood that one spouse may pre-decease the other. Depending upon beneficiary designations and estate planning, the surviving spouse may inherit the deceased spouse’s investment accounts and RMD requirements. As a single filer, the surviving spouse’s income tax bracket will likely be higher than Married Filing Joint. If there is a reasonable belief due to age or health that one spouse will pre-decease the other, it might make sense to do Roth Conversions as Roth IRAs do not have RMDs and are not added to taxable income.
  4. Beneficiary of Your IRA Is Not Your Spouse – Pretax IRA assets passed to someone who is not the account owner’s spouse, also inherit a tax liability. Non-spouse beneficiaries of all IRAs (including Roth IRAs) are now required to withdraw all the money from the account within 10 years of the deceased individual’s passing. Consider a widow naming her adult child as the beneficiary of her $1,000,000 IRA. Her moderately successful adult son, who is making $80,000/yr. in income, must take all $1,000,000 (plus any growth) out of the account within 10 years. His taxable income went from $80,000/yr. to at least $180,000 or more ($1,000,000/10 years = $100,000/yr.). This only gets worse if the beneficiary is in a high tax bracket when they inherit the account. What if that widow were in the 12% bracket, but her son was in the 32% bracket? Using Roth Conversions, the widow could have reduced or even eliminated this future tax liability by paying taxes at her more favorable tax rate.
  5. The Stock Market Is Down – Investors should not make a decision to convert solely based on market performance, but when markets are down resulting in lower portfolio values, the tax burden to convert will be less. You should have a reasonable expectation that the markets will recover. 

A Roth Conversion is not a way to bypass paying taxes. It is a strategy where you are willingly paying the taxes today at a potentially lower rate, on funds you may not need until later in retirement or not at all. Executing this strategy properly involves understanding all the considerations of converting versus not converting and should not be done without the help of a professional. If you are interested in exploring if a Roth Conversion is right for you, reach out to your financial advisor or tax professional.

About the Author | Chris Stennett, CFP®
Chris is a financial advisor and Certified Financial Planner™ practitioner for Saltmarsh Financial Advisors, LLC, an affiliate of Saltmarsh, Cleaveland & Gund. He serves individuals and organizations as a comprehensive financial planner and coordinator of investment activities. His areas of expertise include investment management, income planning, tax and estate planning, and risk management. Connect with Chris on LinkedIn.

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