Is a Roth Conversion Right For you?
Roth conversions are a hot topic right now with investors due to the Tax Cuts and Jobs Act of 2017 and the more recent changes to retirement planning with the passing of the SECURE Act in December of 2019. But the question remains, should I be converting my Traditional IRA dollars to Roth IRA dollars? Like many topics in financial planning, it’s multi-faceted and understanding the effects on your financial plan will help in your decision.
What is a Roth Conversion?
Moving all or part of your money held in a Traditional IRA to Roth IRA. The amount converted is taxable at the Federal and state level in the year of conversion.
Why you should consider moving money from Traditional IRA to Roth IRA
1. No Required Minimum Distributions (RMDs)
Roth IRAs are not subject to required minimum distributions (RMDs) like Traditional IRAs. Upon
reaching age 72, the IRS requires that the owner of Traditional IRAs start taking a portion of the
balance out. This withdrawal is fully taxable at the Federal and state level. Since Roth IRAs are
not subject to RMDs, it gives you greater flexibility in retirement.
2. Tax-free inheritance for your beneficiaries
Although your beneficiaries will be subject to RMDs upon inheriting your Roth IRA, the
distributions are fully tax-free for their lifetime*
*The Roth IRA must be open for five years prior the inheritance to qualify*
3. Tax free-growth
Traditional IRAs grow tax-deferred and are taxed as ordinary income (Fed + State) upon distribution. Roth IRAs grow tax-free. They are not taxable upon distribution. Nobody knows where tax rates will be in the future, but if you feel they will be higher, Roth conversions can make sense depending on your current tax bracket. Ultimately, the returns that matter are the ones you get to keep and avoid paying income tax.
4. You’re in a lower than normal tax bracket
If you fall in a lower bracket than normal for whatever reason. Converting Traditional IRA money to Roth IRA to take advantage of a temporary reduction in the marginal tax bracket.
- Paying the tax due from a Roth conversion with funds outside your Traditional IRA is recommended to avoid early withdrawal penalty, erosion of Traditional IRA dollars, and damaging potential appreciation.
- Converted Roth IRA money needs to stay in the account for at least 5 years prior to withdrawal.
- Pay attention to your marginal tax bracket to avoid unintentional tax consequences.
- Roth IRAs can be an effective tool to reduce estate taxes and produce a tax-free income for your heirs.
- Timing is very important. Typically, Roth conversions are done in the 4th quarter of the tax year to have the full picture of your income tax situation for a given year.
- Roth conversions are a part of a holistic financial plan and should not be made considering only one factor, such as income tax. Always consult with your CERTIFIED FINANCIAL PLANNER ™ professional before taking action.