Should I convert IRA money to a Roth?
- November 7, 2022
- By: Roxanne Alexander, CAIA, CFP®, AIF®, ADPA® Senior Financial Advisor
Should I convert IRA money to a Roth is a complex question. Before 2017 tax law allowed recharacterization (being able to undo a Roth conversion). After 2017, tax law changed and you can no longer undo a conversion. So, before converting an IRA to a Roth, think through your full portfolio and goals. Converting an IRA could push you into a higher income tax bracket for Medicare.
What is a Roth Conversion?
A Roth conversion takes funds from a regular, individual IRA account, pays taxes on the income. And then moves the funds to a Roth account. This is another way to contribute to a Roth. The funds grow tax-free in the IRA account. Since the taxes were already paid, you owe no taxes when you withdraw the funds. This is most effective when you are in a lower tax bracket. We recommend after retirement, but before taking social security and required distributions from traditional IRAs. While planning, remember, you cannot convert funds from an inherited IRA.
How to Time a Roth Conversion
The main advantage of a Roth is the funds are not taxable when you take them out, which can lead to lower taxes in future. Roth funds give you the flexibility to subsidize higher expense years instead of taking excess from an IRA. This strategy assumes the bulk of your funds are in a retirement account. This is an effective strategy for people with larger IRAs, since the conversion happens when they are in a lower tax bracket.
Keep regulations on when you can pull from IRAs and social security without penalty in mind. Time your conversion for after retirement and before age 72 (before age 70.5 before the new tax law changes which extended the required distribution age to 72). This creates an account which grows tax-free and where later withdrawals are not taxed.
How much is the Roth conversion going to cost?
The answer to this questions will be different for everyone. You'll need to consider:
- Pre and post retirement income
- Pre and post retirement location
- Future medicare needs
First ask if you think you will be in a higher tax bracket now vs. later. If your tax bracket will be lower later in life, then you would lose some of the benefits. Then consider your location now and after retirement. If you plan to move from a lower-tax state—like Florida—to a higher-tax state—like California—converting funds before moving may help you avoid state taxes. Hedging against future higher taxes can be a crapshoot. Nobody knows what rates will be in the future.
Pension income, social security income, and IRA distributions may push you into a higher bracket for Medicare (IRMAA). Since Roth accounts have no required minimum distributions, this can lower your taxes in the future. This can help you stay in a lower Medicare bracket.
Do you have other after-tax funds?
If you plan to spend more than your retirement income and minimum IRA distribution, but have other after-tax funds, a Roth account may be less beneficial since you can still avoid having to take excess funds from your IRA. But, high unrealized gains in the after-tax account, may force you into a higher tax bracket anyway, by taking the gains when funds are needed.
Do you plan to leave funds to heirs tax-free?
Gifting money to loved ones or organizations can be a blessing. Your estate planning decisions impact how much they inherit nad their tax bracket. Leaving Roth money to heirs can be helpful to them in future—especially if you have high-income children. An inherited IRA will incur mandatory distributions and create extra income. This is important because the SECURE Act changed the distribution rules from inherited IRAs. You now have to liquidate the account within 10 years vs. life expectancy.
If you have an IRA and name a trust as the beneficiary, the trust will have higher tax rates and required distributions. An inherited Roth is tax free for a trust.
Will you have future tax deductions?
If you already have a large Roth, it may make sense to keep some funds in a regular IRA. This gives you the flexibility to take advantage of future tax situations. For example, if you can offset losses or deductible expenses, you may be able to pay no taxes on a conversion. Keep this in mind for retirement planning. Purchasing into an assisted living facility meets the requirements of a large medical expense. This would cause a large up-front medical deduction, which offsets excess income in that year.
If you have more questions or want to change how you manage your money, reach out to one our financial advisors!
