Prior to the Tax Cuts and Jobs Act (TCJA)—President Trump's tax reform bill that was signed into law December 22, 2017—recharacterization offered you the ability to undo a Roth conversion by allowing you to change the Roth conversion back to a traditional IRA. This is no longer an option, which has caused many to reconsider whether converting to a Roth IRA makes sense.
The benefits that come with Roth IRAs have not changed, so if you make too much money to contribute to a Roth but still want the benefits, you will need to convert either a traditional IRA or 401(k) plan to a Roth. Here are three reasons to consider a Roth conversion:
1. Having Some Retirement Funds in a Roth IRA Is Beneficial
The standard advice surrounding IRAs is to take the tax deduction up front and let the money grow in a tax-deferred account as long as possible (i.e., in a traditional IRA). The idea is to build up the largest possible retirement account value for when you need it later. But is that the best option? Remember, at age 70.5, the IRS requires you to begin withdrawing your traditional IRA money. Called required minimum distributions (RMDs), these withdrawals must be taken throughout your retirement. (For related reading, see: Preparing for Retirement Plan RMD Season.)
However, that strategy may be more costly in the long run. If you've never paid taxes on any of the money you contributed to a traditional IRA, you will likely pay a larger tax bill during retirement because your account value will be much higher. Additionally, it may increase taxes on Social Security and throw you into a higher tax bracket during retirement (when you have less money to pay). That, in turn, could mean your money doesn't last as long as it should. To adjust, you may have to reduce the amount of income you originally planned on using each month or year.
The funds in your Roth IRA are taxed at the time you invest them, so they are not taxed when they are withdrawn during retirement, and Roth IRAs do not have required minimum distributions.
2. You Have Some Control Over Taxes
With Roth conversions, you decide when and how much to convert each year. As a result, you control how much tax you pay each year. By converting some funds before you reach age 70.5, you will have less money in taxable IRA accounts, making required minimum distributions (RMDs) substantially lower. Remember, when you take money out of a traditional IRA, you pay tax on that money in the year in which it's withdrawn. Whether the money is taken out in the traditional manner or via the Roth IRA conversion, you owe taxes for the year you take it out. If you're under age 59.5 when you withdraw, you also pay an additional 10% penalty tax, unless it is for a Roth IRA conversion. Then the penalty is waived. (For related reading, see: Tax Treatment of Roth IRA Distributions.)
One Roth conversion strategy to consider is called the "fill-up-the-bracket" strategy. Here's how it works. You convert just enough of their traditional IRAs to keep you in your current marginal tax rate. Let's say your 2018 tax bracket is the 24% bracket (If filing as an individual, the band is $82,500 to $157,500, if married filing jointly, the band is between $165,000 and $315,000). In the fill-up-the-bracket strategy, you would convert just enough money each year to prevent your adjustable gross income from going above the top income level for that bracket (either $157,500 or $315,000). Granted, you're going to pay more taxes in the years you convert, but would you rather pay more tax while you're making a higher income or in retirement when, presumably, your income is lower? It seems preferable to pay higher taxes when you're making the most money.
3. You Control When and How Much Income You Take
Remember, Roth IRAs do not have required minimum distributions like traditional IRAs. That gives you complete control of when and how much income you take. If you have a pension, you likely don't want or need as much income from your IRAs. If you have saved enough and have sufficient funds in your taxable investment accounts, you may not want to take money out of your IRAs. You pay ordinary income tax rates on money taken out of traditional IRAs. Money withdrawn from taxable investment accounts held over one year gets lower, more favorable capital gains tax treatment (either 15% or 20% under current law).
Having your investments diversified across different types of investment accounts (taxable accounts, traditional IRAs and Roth IRAs) offers the opportunity to develop a withdrawal strategy to maximize your income while minimizing the taxes you pay on that income. Converting to Roth IRAs increases the amount of money you can withdraw tax-free at retirement. The flexibility and control you get from Roth IRAs are much greater than from other types of retirement accounts. So, if you don't want to take money out of your Roth, don't. It will continue to grow tax-free in the account.
Take Control of Your Retirement Income
All of my top three reasons to convert to Roth IRAs have to do with one thing—control. Roth IRA conversions allow you to decide when and how much to convert each year, how much tax you pay when, and how much income you want and when you take it, making them a viable option in your retirement plan even if you can no longer recharacterize them in the future.
(For more from this author, see: Direct vs. Indirect IRA Rollovers: Which Is Best?)