The advantages of converting a traditional IRA savings to a Roth IRA are well-known, having been finely honed in the nearly two decades since the Roth was born. In fact, the long-term tax benefits of a Roth IRA seem so obvious that you (assuming you qualify for a Roth) simply would never consider making the switch to a traditional individual retirement account.
You may want to rethink that assumption. Even if the Roth IRA was initially the wisest choice for your retirement savings, evolving circumstances may dictate that you should consider converting (or recharacterizing in IRS-speak) to a traditional IRA. Here are five compelling reasons.
1. You’re Broke
The simplest (and perhaps the bleakest) reason might be that for whatever reason – personal or professional – you’re cash poor. To put it in a gentler way, if you can no longer comfortably pay taxes on the money you're contributing to your Roth IRA (Roths are funded with after-tax income, remember), it may be best to convert to a traditional IRA. You wouldn’t be the first one to make this move for this reason, and you certainly won’t be the last. "In a situation where someone is tight for cash, a traditional IRA contribution will provide more deductions and therefore more cash in hand after tax filing," says David S. Hunter, CFP®, president of Horizons Wealth Management, Inc., in Asheville, N.C.
2. Your Account Underperformed
This may not be quite as bleak a scenario as simply being too broke, but it’s certainly another popular reason to convert. If the contributions that you originally sunk into your Roth IRA have suddenly lost value, due to market forces, Uncle Sam is rather unforgiving: You're still taxed on the dollars you've put in. So, you just might save on your tax bill by converting to a traditional IRA. With the switch, you defer the reckoning, so to speak—because with regular IRAs, taxes are paid when funds are withdrawn. And even then, you are taxed only on what you take out.
If you have planned ahead, "sometimes you can split the conversion into two buckets, and if one goes up 15%, keep that as a Roth and if one goes down 15%, recharacterize that one," says Scott A. Bishop, CPA, PFS, CFP®, partner and executive vice president of financial planning, STA Wealth Management, LLC, Houston, Texas.
3. You Made Too Much This Year
Contributors to a Roth IRA must meet very specific adjusted gross income (AGI) levels. In 2018, a single filer's AGI must be less than $135,000; and that for married couples filing jointly, less than $199,000. Married couples filing separately are treated like single filers if they did not live with their spouse "at any time during the year." If they did, their AGI must be under $10,000.
If you exceed any of these levels, you’re automatically ineligible for a Roth IRA, and you’ll need to recharacterize one you've set up within the penalty-free timeframe allotted by the IRS. If you're near the top of the AGI limit for your category, you'll only be able to contribute a reduced amount to your Roth so check with your tax advisor.
4. You're Making Less in the Future
You've crunched the numbers on your projected annual income after you retire, and realized you're going to be in a significantly lower tax bracket. That means you won't benefit as much from the kind of tax-free distributions that are a key feature of Roth IRAs. But if you convert to the traditional IRA (whose distributions are taxed upon withdrawal), you will benefit from a smaller tax bite now.
"If you are expecting to be in a lower tax bracket in retirement, which is common, then it makes more sense to utilize a traditional IRA," says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of "Index Funds: The 12-Step Recovery Program for Active Investors." "You forgo paying taxes on contributions at your current higher tax rate and then pay taxes in retirement at a lower tax rate on distributions." Just keep in mind that required minimum distributions begin at age 70½ for a traditional IRA (they're not required for a Roth).
5. A Roth Conversion Bumped up Your Tax Bill
This scenario can take some investors by surprise. Did you recently turn a traditional IRA into a Roth IRA primarily to save on taxes in the future? If so, it can come as a shock when the Roth IRA conversion process ended up increasing your tax bill now.
"A smart choice [before a conversion] is to have an analysis created by an accountant to see what the tax ramifications will be," says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.
If you converted a traditional IRA worth, say, $100,000 into a Roth IRA, it's as if your taxable income increased by $94,500 – the $100,000 minus the $5,500 you're allowed as an annual contribution to the Roth – and that bumps you into a higher bracket. Within the world of retirement accounts, this scenario is a true paradox, but it might make converting back again worth it.
The Bottom Line
Whatever your reason for converting a Roth IRA to a traditional retirement account, keep in mind the calendar deadlines that the IRS imposes. Conversions must be completed by the final date allowed to file or amend your previous year’s taxes. The standard date is October 15.