By Thomas DiLorenzo,
Are you a good candidate for a Roth conversion? It depends on your particular circumstances. While there are many variables to consider, start by answering these key questions.
Do you understand the differences between a traditional IRA and a Roth IRA?
With a traditional IRA, you always have the option to transfer all or some of the account's assets to a Roth IRA. A Roth conversion lets you pay taxes on your retirement savings now in exchange for the opportunity to receive tax-free distributions from your savings down the road (typically when you're retired). This creates a hedge against the possibility that you'll be subject to a higher marginal tax rate when you're retired than the rate you're paying now.
Unlike one of the main draws for a traditional IRA, a Roth IRA does not offer a current-year tax deduction on contributions, but it does have the potential for tax-free distributions. Other key considerations include:
- Only assets that have already been taxed can be contributed to a Roth IRA
- Contributions can be withdrawn tax-free at any time without triggering a 10% early-distribution penalty
- Amounts converted from a traditional IRA to a Roth are not subject to taxes upon withdrawal from the Roth
- Conversion contributions can also be withdrawn penalty-free once they've been held in the Roth account at least five years
- Generally, any earnings on your account can be withdrawn tax-free and penalty-free once you've held the account at least five years and reached age 59½ (although there are certain exceptions to the five-year rule)
Assets held in other forms of a traditional IRA account typically qualify for a Roth IRA conversion, including assets in a rollover IRA, a SEP (Simplified Employee Pension) plan, a SIMPLE (Savings Incentive Match Plan for Employees of Small Employers) IRA and a SARSEP (Salary Reduction Simplified Employee Pension Plan). Additional types of assets that typically qualify for conversion include money held in an employer-sponsored 401(k), 403(b), 457 or annuity plan (as long as the transferred assets do not include Roth contributions to the plan).
Can you afford the taxes due on a conversion?
Converting a traditional IRA to a Roth IRA is a taxable event. When you convert, you owe taxes on any portion of the conversion attributable to earnings or pre-tax contributions coming from the traditional IRA. You can't "cherry-pick" by converting only after-tax contributions, which are nontaxable upon conversion or distribution; any amount converted will be prorated to include both nontaxable and taxable portions based on the nontaxable/taxable breakdown of your entire account. If you have more than one traditional IRA, the prorating will be based on the nontaxable/taxable breakdown of the total assets in all of your combined traditional IRA accounts.
For example, if the total value of all your traditional IRAs is $100,000, with $10,000 (10%) consisting of nontaxable contributions, this does not mean you can convert $10,000 on a tax-free basis. Since the total makeup of your traditional IRAs is 10% nontaxable/90% taxable, if you convert $10,000, then only $1,000 (10%) of this will be nontaxable and the remaining $9,000 (90%) will be taxable upon conversion.
When you're converting part of a traditional IRA, you can withdraw additional assets out of the account to pay the taxes due upon conversion. However, if you're under age 59½, you will owe a 10% early-distribution penalty, in addition to taxes, on any amount distributed from the traditional IRA but not converted. Also, any traditional IRA dollars you use to pay taxes will mean less money available to help fuel the potential future tax-free growth of your Roth account.
Generally, a conversion makes sense only if you can pay the taxes due using cash from a separate source other than your traditional IRA.
Have you considered your current tax bracket vs. the one you'll be in for retirement?
Considering your anticipated tax bracket at the time of retirement could significantly change your tax planning. If you think you will be in a higher tax bracket when making withdrawals in retirement, converting in order to pay taxes now rather than later might make sense. Conversely, if you expect to be in a lower tax bracket in retirement, converting might yield less of an advantage, but you may want to explore the idea. If you’re concerned that a full conversion will put you into a higher tax bracket now, you might consider converting only a portion of the assets held in your traditional IRA.
Have you considered when you’d like to take distributions?
The longer you're able to put off taking distributions from a Roth account, the longer you’ll be able to take advantage of the potentially tax-free buildup of earnings. Generally, if you’re 10 or more years from having to take a distribution, a conversion might make sense. If you’re closer to having to tap into your IRAs, you might be better off continuing to defer taxes on assets in your traditional IRA instead of converting and triggering taxes on these assets now.
Does your traditional IRA contain assets you hope to leave behind?
Assets you intend to leave to your heirs may be better off in a Roth IRA than a traditional account. A Roth IRA has no required-minimum-distribution (RMD) rules saying you have to start taking money out of your account once you turn age 70½. In fact, you can keep money in a Roth IRA indefinitely, making it easier to leave behind as inheritance.
As soon as a non-spouse beneficiary inherits a Roth IRA, he or she must begin taking required minimum distributions from the account. However, these distributions are tax-free, which leaves more assets available for the beneficiary's use.
Might you be a candidate to make an "indirect" Roth contribution?
If you earn too much to contribute directly to a Roth IRA, you may still be able to transfer funds into a Roth account by making a nondeductible contribution to a traditional IRA, then converting the traditional account to a Roth account. If you convert immediately upon contributing to the traditional IRA and have no earnings or pre-tax contributions in this or any other traditional IRA, you will incur no taxes upon the conversion. If, however, you do have earnings or pre-tax contributions in this or another traditional IRA, a prorated portion of the amount you convert will be taxed.
Is a Roth IRA conversion right for you?
Deciding whether a Roth IRA conversion would work well for you can get complicated. Consult with a tax advisor or financial planner to evaluate all the variables that may apply to your situation.
Thomas DiLorenzo is a Senior Manager of Employee Financial Services at Ernst & Young LLP