How can I determine if converting an IRA to a Roth IRA will be worthwhile?
I'm 65 years old and retired. I would like to convert some of my traditional IRAs to Roths in the coming years to reduce my RMDs. How can I figure out if this strategy will be worth it considering the additional tax hit? Right now, I'm in the 15% tax bracket.
As you are aware, one of the benefits to converting to a Roth is the avoidance of having to take the required minimum distributions (RMD) after the age of 70.5 each year. Converting a traditional IRA to a Roth gives you this flexibility after you reach retirement age. Contributions to a Roth IRA come from after-tax income, so there are fewer restrictions on how you use these assets. Unlike a traditional IRA, which has a required mandatory distribution (RMD), a Roth IRA has no required mandatory distribution (RMD), so you may continue to use your Roth IRA as an investment fund for as long as you like. With a traditional IRA, you must begin to collect distributions by the age of 70.5 through annual RMDs. The RMD for each year is calculated by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy. Again, this rule does not apply to Roth IRAs.
Keep in mind that the IRS also allows you to re-characterize your Roth IRA back to a traditional IRA which may be valuable if your investment value declines or if your financial situation changes and you do not want to pay your tax bill that year, as you can recoup the taxes paid for the conversion.
Converting while in the 15% tax bracket can be a smart money move at any age. The critical element is that you will pay income tax on the amount you convert, this allows Roth IRA holders the opportunity to eliminate future taxes on their retirement plans, thereby compounding their total return. There is no minimum dollar amount for a Roth IRA conversion, so you may choose to convert a small portion of your account every year if appropriate. Therefore, individuals on disability, students, or unemployed may be suitable for a conversion. Another case for a partial conversion done over a period of years is when someone retires early before taking Social Security.
A conversion may also be appropriate if you are well into your retirement. From an estate planning perspective, if your estate is large enough by converting to a Roth IRA, you could reduce estate taxes as well. Depending on your individual tax bracket, income tax on the converted amount may be less than the estate tax for that amount.
Your heirs will also receive Roth funds tax-free versus at their top tax bracket.
One precaution of converting is that taking on that extra income could push you into a higher tax bracket. More income could result in more taxes, or it could affect eligibility for tax deductions or credits. As always, it is best to consult with your CPA and Investment Advisor before making any decisions that pertain specifically to your individual financial situation.
I really like the idea of performing some kind of systematic Roth IRA conversion each year over the next 5 years. While there's no way to know exactly which route is best for you, 15% is a pretty low tax rate to pay on converted amounts. Ideally, you'd like to feel comfortable that the funds which were converted can perform in the Roth IRA and make up the 15% tax you paid; the lower the tax rate, the better odds you have of regaining the funds you paid in tax.
With this said, I often like to take a two-pronged approach here, the first is a systematic Roth conversion strategy. This would be a fixed amount every year and it would occur regardless of what your portfolio is doing.
The second strategy is a bit more complex as it would be dynamic and reactive to the conditions of your portfolio. Simply put, if your portfolio contains volatile elements you've purchased and plan on holding for the long term, chances are that these investments will experience a decline at some point. If an investment falls by 50%, it can make sense to convert just that single investment at a 50% discount, then hope that the rebound occurs in the Roth IRA. Again, this is if you are knowingly holding something that you expect to oscillate and you're comfortable trying to use these oscillations to optimize your tax situation. Further, you may leave the window open for recharacterization of the Roth IRA conversion if you convert this hypothetical investment into its own Roth IRA. This is where the situation gets very complex and you should be careful.
I must mention that the above information contains a lot of tax and investment experience to implement and I would absolutely recommend consulting your team of CPAs and advisors before doing anything. With more specific details, I'd feel comfortable helping to build you an approach, but please consider the above just for educational purposes only and not as tax or investment advice.
Feel free to shoot me a message if you'd like specific insights.
Adam C. Harding, CFP
It requires looking at projections. If you are collecting Social Security, you may subject that to additional tax. If you are not, then I would ask - given all of the future possible tax scenarios for your account, when would you pay less than 15%?
If you move to a lower tax state... maybe you don't convert.
But, if your beneficiaries would pay more, if you would pay more later, if you think tax rates may rise at some point (yes, they may go down, but they can always go right back up and up higher!).
The nice part about the conversions is you get a 'redo' if you determine next year that a conversion didn't make sense. It's a freebie. Give it a shot, if it doesn't work, undo it.
You need to seek out the advice of a competent retirement income advisor that focuses and specializes in income distribution. You aren't just looking at your marginal tax rate, but you are also looking at your effective tax rate. By not converting your IRA over, you may be setting yourself up for a big tax problem 5 years down the road when your required minimum distributions start. You will be forced to take withdrawals out of your IRA and it is taxed at ordinary income rates, counting towards your Provisional Income threshold and your Modified Adjusted Gross Income threshold. This could then cause up to 85% of your Social Security to be taxable, double or triple your Medicare Part B premiums, and cause you to be as high as a 46% effective tax rate.
Get a full, year by year analysis on tips and tricks that you may be able to use to convert your IRA over at 50 cents on the dollar, and save money on future Social Security taxes, Medicare B penalties, and income taxes.
Reach out if you want more details for your situation.
If you are compter savvy, just Google "Roth Conversion Calulator" and you will get lots of options. NerdWallet, Fidelity, Investopedia, TIAA Cref, Forbes, and even the AICPA (professional CPA organization) have them. Try a few and see if you get a consistent answer.
Generally, I don't love the Roth conversion for seniors unless, 1) your goal is to not spend the Roth on your retirement, but leave it for your kids and grandkids, or 2) you know with some kind of certainty that your tax bracket is lower now than it will be in 10-15 years when you decide to take withdrawals from the Roth.
Also, remember you need to have enough non-IRA cash on hand to pay your extra income taxes from the Roth conversion without taking MORE out from your traditional IRA, therefore triggering a higher tax bill requiring you to again take more from the IRA to pay for it, and on and on and on.
Definitely talk this over with your CPA before making a move.