Should you do a Roth IRA conversion?
And, what is that?
You may have heard of a Roth IRA conversion and are wondering (a) what it is and (b) should you do it?
What is a Roth IRA conversion?
As the name implies, you "convert" a pre-tax IRA into a Roth IRA.* Anyone can do this, any time, for any portion of your pre-tax IRA balance. You’ll owe income tax on the amount converted, just as you would if you took a distribution from a pre-tax IRA.
This can be a sensible tax planning move, depending on your present and future circumstances. It can also be a mistake at the wrong time.
Should you do it?
A Roth IRA conversion may be prudent, if you answer YES to both of the following questions:
Is your taxable income — and your marginal tax bracket — in this current year lower than what you expect it to be during your retirement?
Do you have savings available outside of your IRA to pay the taxes you'd owe from doing a conversion?
There are some secondary considerations that make this decision more complicated to sort through:
1. Where do you live now versus in your future retirement?
States tax IRA distributions differently, including not at all. For example, if you live in a high income tax state now (say CA) but expect to retire in a no income tax state (say FL), you may not want to do a conversion now as you'll pay state income tax on the converted amount that you could avoid if you distributed the money later when residing in FL.
2. Do you want to minimize this year's adjusted gross income (AGI)?
Doing a conversion will increase your AGI and if you want to qualify for certain income-based programs such as need-based college financial aid for your kids, income-dependent student loan repayment plans, Obamacare subsidies, federal pandemic relief checks, or (ironically) eligibility to contribute to a Roth IRA, you won’t want to push your AGI above whatever income threshold is relevant to your situation.
3. Do you want to reduce your future AGI?
Doing a conversion now will decrease your future AGI in retirement because of reduced required minimum distributions from your remaining (now smaller) pre-tax IRA. This can be useful, for example, if you're a high-income retiree and are trying to minimize future Medicare surcharges. It may make sense to do a conversion and increase your AGI now so that it will be lower in future years and you can reduce or avoid these surcharges.
4. Can you predict the future?
Probably not. And you may not know where you'll retire, your future taxable income, or future tax policy and income tax rates. This makes it a trickier decision but possibly a good reason to tax-diversify your asset mix (next point).
5. Should you tax-diversify your assets?
From a tax standpoint, investment assets reside in one of three buckets:
Pre-tax retirement accounts — you pay ordinary income tax on all distributions
Taxable investment accounts — you pay tax on the interest, dividends, and capital gains
After-tax retirement accounts — you don’t pay any tax on gains or distributions
The third bullet is the Roth IRA. If most of your net worth is primarily in the first bucket (eg, a pre-tax IRA or 401k), then it may be sensible to convert some of it to a Roth as you’re diversifying your risk around future tax policies and tax increases.
When is it not a good idea?
Generally, if you currently have a high income and you reside in a state with a high income tax, now is probably not the moment to do a Roth IRA conversion.
Also, if all of your net worth is in pre-tax retirement accounts, it’s probably not sensible to do a conversion as you don’t have spare cash available to pay the taxes.
When may it be a good idea?
Here are two examples of when it may make sense to do a conversion:
You're recently retired in your early 60s, your taxable income is currently low because you're living off your savings, and you expect your income to increase in your 70s when you begin Social Security and IRA distributions. Now may be a good time to do a Roth IRA conversion.
You're currently in graduate school with little or no income and you have a previous pre-tax IRA or 401K. This may be a good time to do a conversion, assuming you have the cash to pay the tax that will result and you expect your income to be higher in the upcoming years.
Roth IRA conversions can be a helpful tax planning tool. But, it's not all or nothing. You can convert as little or as much as you chose and then take a fresh look at your financial situation each year.
Finally, keep in mind that while a well-timed Roth conversion can save you some money over your lifetime, it won’t be a life changing amount. In most cases, it is a relatively small total savings.
* Note that a conversion is different from a rollover which typically refers to rolling over an old 401K, 403B, or IRA into an existing or new IRA. You may think you are "converting" a 401K into an IRA (and in plain english, you are) but in IRA-speak, it's a rollover. (Yes, the terms are confusing.)
Thank you; leaves me with lots of questions!