Should I Consider a Roth Conversion
Contributions to Roth IRAs are taxable and the distributions from the Roth IRAs during retirement are then tax-free. Therefore, if you expect your tax rate to change in the future, you will want to make sure that you are taking advantage of a lower tax rate, whether that is when you are contributing to the IRA now or withdrawing from the IRA during retirement.
The general rule of thumb on Roth conversions is that if your tax rate during retirement will be higher than it is now, you should convert to a Roth IRA. However, if your tax rate during retirement will be lower than it is currently, you should not convert to a Roth IRA. These are big generalizations.
Even if your marginal tax rate during retirement will be lower than today, a Roth conversion might make sense. Calculators on the Google can help provide break-even analysis. Charles Schwab has a good one at-
Other Factors to Consider with Roth Conversions
There are many side benefits of Roth Conversions. For instance, there are no minimum distributions required from Roth IRAs once you reach 70 ½ years old. This is a big deal. Many retirees do not like having to take required minimum distributions (RMDs) since it increases their taxable income, and it might further increases taxes on social security benefits or they might start to lose other tax deductions, or both.
There are also major tax benefits if you expect your IRA assets to soar in value. For example, if your IRA contains a stock that is currently valued at $20 per share, but you expect it to be worth $40 per share at retirement, you want to pay the conversion tax now as opposed to paying tax on withdrawals later when the assets in your portfolio have doubled in value.
Finally, the amount paid on the Roth conversion will reduce your taxable estate.
However, there are also a number of negative side-effects of Roth Conversions.
The additional income recognized from a Roth conversion increases Modified Adjusted Gross Income (MAGI). This can trigger other taxes such as the 3.8% Medicare surtax on unearned income which impacts singles with MAGI over $200,000 and couples with MAGI over $250,000.
Roth conversion income isn’t included in net investment income, which is used to calculate the Medicare surtax. However, the Roth conversion will increase MAGI in the year of conversion which will leave more of your unearned income exposed to the Medicare surtax.
The additional income from a Roth conversion can also trigger a monthly surtax on Medicare premiums on top of the regular Part B and D premiums. The surcharge impacts singles with adjusted gross income (AGI) over $85,000 and couples with AGI over $170,000. The increase to AGI caused by Roth conversion income can trigger a maximum Medicare premium hike of $3,700.
Social Security benefits can be taxed at a higher level thanks to the increase in AGI caused by the Roth conversion.
The extra Roth conversion income can impact your ability to write-off personal exemptions, itemized deductions, passive losses, and other income-based phase outs.
Despite all of the negative side-effects of Roth conversions, there are a number of ways to mitigate these pitfalls. Doing partial conversions over several years can help alleviate some of the problems associated with the spike in AGI caused by a Roth conversion. For example, if converting $500,000 in one year sends your tax rate into the stratosphere, and you phase out of all sorts of tax benefits, then our suggestion is to convert a little at a time.
How much is too much? We can help model precisely the amount to convert each year so as to maximize your tax benefit. $100k? $80k? $140k? We can find out for you!
Also, if you decide to convert your IRA into a Roth IRA, you have until October 15th of the following year to change your mind. If you change your mind during this time, you can undo the switch and recoup all of the taxes paid. This is called recharacterization.
Finally, creating separate Roth IRAs for different asset classes provides some additional security. For instance, if a Roth IRA contains assets that decline in value significantly before October 15th, then you can convert that Roth back into a traditional IRA while leaving the rest of your assets to reap the benefits of a Roth IRA. Read that again ‘cause this is another cool thing to keep in mind when converting.
If anyone says you should always do something or never do something without looking at all the aspects, we suggest finding a new advisor. Yes, there are slamdunk Yes answers and No answers. But Roth IRA Conversions is not a slamdunk without some fact gathering.