Meridian Blog

To convert or not to convert – pay the tax now or pay them later? These are just a few questions many investors are asking themselves and for good reason. Converting part of a traditional IRA into a Roth IRA means you pay income tax now in exchange for tax-free growth and tax-free qualified withdrawals later, plus no required minimum distributions (RMDs).

However, it’s essential to understand the fundamentals of Roth conversions and when they do or don’t make sense.

Primers on Roth IRA Conversions

• Tax now, tax-free later. When you convert, the converted amount is taxable in the conversion year as ordinary income (unless it’s after-tax basis). Once inside a Roth, future qualified distributions are tax-free.
• No income limits. Anyone can convert — there’s no Modified Adjusted Gross Income cap for conversions (unlike direct Roth contributions).
• Five-year rules. Each conversion has its own 5-year clock for determining whether converted amounts can be withdrawn penalty-free; earnings also have a separate 5-year rule for tax-free withdrawal. This matters if you may need converted funds within five years.
• No take-backs. Since 2018, you can’t “undo” / “recharacterize” a conversion. Once you convert, the tax consequences stick for that tax year.
• Deadlines. You have until December 31 each year, unlike Roth contributions, which can be funded up until the tax filing deadline.

When a Roth Conversion Makes Sense

Each client’s situation differs, so these are decision triggers rather than rules. Before deciding to do a Roth conversion, we highly recommend consulting with both your accountant and your financial advisor.

1. You expect a higher tax rate later.
   If your current tax rate is lower than the tax rate you expect in retirement (or than future rates you expect for you or your heirs), it can make sense to pay tax now and lock in tax-free withdrawals later.
2. You’re in a low-income year (or predictable low-tax window).
   A temporary fall in income — a job change, retirement, business loss, or the year between jobs — can create an attractive window to convert because the tax hit will be smaller. Staggering conversions in small chunks over more than one year allows the investor to stay within a lower bracket. We tend to call this “filling up the tax bracket”.
3. You want to avoid RMDs (Required Minimum Distributions)
   RMDs are the financial version of mandatory parent-teacher conferences: you can’t skip them. However, Roth IRAs are not subject to RMDs during the owner’s lifetime. Converting before RMDs begin can reduce future required taxable distributions from traditional accounts and help with estate planning. (Note: if you’re already RMD age you must take that year’s RMD before converting amounts from IRAs.)
4. You want tax diversification.
   Having both pre-tax and Roth buckets gives flexibility to manage taxable income in retirement, potentially reducing taxes on Social Security, Medicare premiums (IRMAA), and the net investment income tax.
5. You want to maximize your estate for your heirs.
   Roths also pass tax-free to heirs (subject to inherited-Roth rules) and therefore don’t create a tax burden for your heirs. This is an important thing to consider as traditional IRAs require non-spouse beneficiaries to distribute funds within a 10-year period and, in certain cases, take an annual RMD – all of which is counted as taxable income.
6. You can pay conversion taxes from non-retirement funds.
   Paying the conversion tax from outside cash (not from the IRA being converted) preserves more of the account’s value for tax-free growth and avoids eroding retirement savings. If you must use IRA funds to pay the tax and are under 59½, that can trigger penalties if you withdraw the funds from the Roth before the 5-year period and compounding is lost.

Source: https://www.fidelity.com/viewpoints/retirement/roth-ira-conversion-after-50

When a Roth Conversion Doesn’t Make Sense

• Converting would spike you into a much higher bracket or trigger significant surtaxes (NIIT or higher Medicare premiums aka IRMAA). The marginal tax cost can outweigh future benefits. Factor Medicare IRMAA and the 3.8% Net Investment Income Tax (NIIT).
• You already have low expected taxes in retirement. If your future tax rate will be lower and you’re not seeking Roth benefits, conversion may not be beneficial.
• You plan on giving a large amount of your traditional IRA to charity through Qualified Charitable Distributions. Retirees can use this strategy to satisfy their RMD without realizing taxable income.
• You will need the money soon. If you are needing the money from the IRAs within the next five years it isn’t a good candidate for conversions because your assets may not have time to recoup the taxes you would have to pay.
• You can’t pay the tax from outside cash or assets. Paying taxes from the converted assets means that money won’t be growing tax free for retirement, which undermines the very purpose of a Roth IRA conversion.

Strategies to consider

• Partial conversions. Instead of going all-in, converting just enough to stay in your current tax bracket is a commonly used strategy.
• Plan around life changes. Empty nest years (before Social Security and RMDs) can be prime conversion windows as taxable income tends to be lower.
• Coordinate with other tax moves. If you are going to be lumping itemized deductions such as large charitable donations in one year, it may be a prime year to convert. **Always double-check with your accountant!

Roth conversions, like any responsible decision, may mean short-term pain (i.e. taxes) for long-term gain. Thoughtfully weighing your options now could mean a tax weight off your shoulders in the future.

Don’t let the uncertainty of Roth conversions scare you and be a weight on your shoulders.