FORECASTS & TRENDS E-LETTER
By Phil Denney
June 4, 2024

Thinking About a Roth Conversion?

IN THIS ISSUE:

1.  What is a Roth IRA Conversion?

2.  Who Should Possibly Convert?

3.  Who Should Probably Not Convert?

4.  Roth IRA Conversion Rules You Need to Know

More and more people are asking us if a Roth IRA conversion is right for them. There are many considerations to understand, so today let’s take a look at what a Roth IRA conversion entails, the pluses and minuses of converting and some of the rules you need to know.

Please remember that the following is not specific advice on Roth IRA conversions but general information. Be sure to talk with your tax accountant and investment advisor before making a decision to convert.

What is a Roth IRA Conversion?

The difference between a Roth IRA and other types of IRAs is that the Roth account is funded with after-tax dollars. That means you pay taxes on funds before contributing them to the Roth, and you can’t deduct contributions from your taxable income.

However, the money in the Roth account grows tax-free and you can withdraw funds after you retire without paying taxes.

You can convert funds in pre-tax IRA accounts to a Roth IRA. This includes traditional IRAs, SEP IRAs and Simple IRAs. When you convert pre-tax money from a regular IRA to a Roth IRA, you must pay taxes on it at your current rate. The conversion amount is treated as regular income, which can bump you into a higher tax bracket and cause a high tax bill for the conversion year.

Who Should Possibly Convert?

Below are some positive considerations from Charles Schwab:

• You believe your tax bracket will be higher in retirement. No one really knows what the tax rates will be when you retire, but the assumption is that your tax rate will be higher. One tax you won’t pay is payroll taxes on your IRA distributions. That one fact points to potentially lower taxes in retirement.
• You want to maximize your estate for your heirs. Converting some or all your IRA monies to a Roth IRA now allows your savings to grow tax-free for your heirs.
• Your accounts aren’t diversified by tax treatment. By converting some of your traditional IRA money to a Roth IRA, you will have assets that won’t be taxed when withdrawn, potentially allowing better management of your taxable income.
• The Tax Cut and Jobs Act of 2017 created generally lower tax rates for 2018 through 2025, presenting an enticing opportunity to convert traditional retirement savings to Roth accounts at today’s lower rates. Under current law, individual income tax rates will revert to higher 2017 levels, plus inflation adjustments, in 2026. Dangerous to assume Washington D.C. will do the right thing here, no matter what the results of the November election.

Who Should Probably Not Convert?

• You are nearing or in retirement and need your traditional IRA to cover your living expenses. Money you convert to a Roth IRA must not be touched for at least five years. If you tap it before this time is up, you will pay taxes on any earnings from the Roth IRA. If you are under age 59 ½ and you need this money, you will pay a penalty tax on the earnings.
• You are currently receiving Social Security or Medicare benefits. A Roth conversion could potentially increase your taxable income to where your Social Security benefits would be taxed. Roth conversions require you to understand the potential effect it has on your Medicare premiums. When funds are converted, the IRS sees this as income that has come out of the traditional IRA, which can raise your adjusted gross income past a certain level, thereby increasing the premiums you pay for Medicare B and D.
• You don’t have the money to pay for the conversion tax. Using IRA funds to pay the taxes on the conversion in many cases could negate the benefits of converting. A better option is paying the tax with cash in hand. Keep in mind that the IRS wants their cut on the conversion immediately. If you underpay taxes prior to the tax deadline, you might be required to pay a penalty.
• You believe that you will be taxed at a lower tax rate when you begin to take withdrawals in retirement. Or your beneficiaries will be in a lower tax bracket.

Roth IRA Conversion Rules You Need to Know

Though there are income limits that apply to contributing to a Roth IRA, these income limits do not apply to Roth IRA conversions. With that in mind, here are some important Roth IRA conversion rules you need to learn and understand:

Accounts You Can Convert:
While the most common Roth IRA conversion is one from a traditional IRA, you can convert other accounts to a Roth IRA. Any funds in a qualified retirement plan that are eligible to be rolled over can be converted to a Roth IRA.

60-Day Rollover Rule:
You can take direct delivery of the funds from your traditional IRA (check made payable to you personally), and then roll them over into a Roth IRA account, but you must do so within 60 days of the distribution. If you don’t, the amount of the distribution (less non-deductible contributions) will be taxable in the year received, the conversion will not take place, and the IRS 10% early distribution tax penalty will apply.

Trustee-to-Trustee Transfer:
This is the easy way to work the transfer. You simply tell your traditional IRA trustee to direct the money to the trustee of your Roth IRA account, and the whole transaction should proceed smoothly.

Same Trustee Transfer:
This is even easier than a trustee-to-trustee transfer because the money stays within the same institution. You simply set up a Roth IRA account with the trustee who is holding your traditional IRA and direct them to move the money from the traditional IRA into your Roth IRA account.

Note that, if you don’t follow the rules outlined above and your money doesn’t get deposited into a Roth IRA account within 60 days, you could be subject to a 10% penalty on early distributions in addition to income taxes on the converted amounts if you’re under the age of 59½.

And, as I already mentioned, you’ll have to pay income taxes on converted amounts regardless of which rule you choose to follow above. You’ll report the conversion to the IRA on Form 8606 when you file your income taxes for the year of the conversion.

The decision to convert to a Roth IRA doesn’t have to be all or nothing. You can do it over a period of years or decide on an annual basis an amount that makes sense for you after considering the tax implications.

Investopedia has some good information on conversions. You may find it useful to take a look at the online Roth IRA conversion calculator by Charles Schwab & Co.

“The world isn’t falling apart but is actually falling into place.” Think about it.

Thanks for reading,

 

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