Before determining if a Roth Conversion has merit or not, It’s important to first try to understand a little about the Roth Conversion.
A Roth conversion involves taking money from your traditional IRA and moving it to a Roth IRA.
This can either be done to a partial IRA balance or the entire sum. The purpose of this move is to shift the tax benefit from growing tax deferred only to paying tax now and being able to make a tax free withdrawal during retirement without restrictions. (Restrictions like Required Minimum Distribution)
Unlike the 401K or traditional IRA which has money placed into them with tax deferred funds, (Which means that when the money was taken out of your paycheck it was not taxed- for example someone who earns $50,000 a year and in the 20% tax bracket would pay$10,000 in taxes. But if $5,000 was placed by the employee into his employer’s 401K then this employee would only be taxed on $45,000 at 20% tax,which would be $9,000- that would be an immediate tax benefit of $1000), where the money grows tax deferred (Which means that the money you put into these accounts will not be taxed until it’s taken out.- for example you put $1000 dollars into a 401K and that money earns a 1% dividend= $10. The account holder will not pay tax on that $10 earning in this current year), and the 401K or traditional IRA funds would only be taxed when a withdrawal is made in retirement. (Which means that you pay tax on the portion of money taken out during retirement such as the Required Minimum Distribution- if however money is taken out before retirement unless it part of some exceptions there would be a 10% penalty), in contrast the Roth IRA is only taxed during the year that you make the conversion and after that it has the benefit of both growing tax free and having tax free withdrawals during retirement.
You however, will have to meet certain requirements in order to qualify for the Roth conversion.
How does a Roth Conversion compares to your traditional IRA?
The following is a brief IRA versus Roth analysis.
The traditional IRA requires that once you get to 70 ½ you should take a required minimum distribution RMDs every year, this means that whether you need the money or not, you are required to withdraw a certain portion of it every year which means you lose out on the tax free growth of this money. (If you don’t do the RMD the penalty is 50% of what should have been taken out!) With the Roth IRA however, you can leave the money to sit and grow tax free until you decided to take the money out and even then its a tax free withdrawal.
Tax on Inheritance
The Roth IRA lets you leave behind a tax free inheritance to your heirs. Even though your heirs will be expected to make annual withdrawals, there is no tax on these withdrawals as long as the Roth account has been in existence for at least 5 years
Taxation on Sole Surviving Spouse
The traditional IRA can become a great burden on a surviving spouse as the taxation on the withdrawals are recalculated and a single tax will be levied on the surviving spouse’s withdrawals which actually becomes a huge burden. The Roth IRA will prevent this from happening and takes it easier on the surviving spouse.
Capital Gains Tax
When you convert to Roth IRA, you can benefit from a lower capital gains tax. This may depend on your planning though. With good planning you may be able to keep your income at a rate that will not incur any capital gains tax.
IRA will result in a higher cost of medicare paid after retirement since your income will increase which means your medicare payments will be higher. With the Roth conversion you are also able to avoid making higher medicare payments since you will not be making the mandatory annual withdrawals which would make you have to pay more.
So is the Roth conversion something you should consider?
Deciding whether to make the conversion could hinge on a few aspects.
First of all you need to consider whether you may need the money within 5 years or less. The conversion to Roth requires a holding period of 5 years and within that time you need to have a different income especially if you are already retired.
You will need to do the calculations to see if you will not end up with a higher tax debt than what you were trying to save
You may also need to consider your current income and then calculate whether you should convert all or part of your IRA because within the year of conversion, you are going to be taxed and it is possible that you may get bumped up to a higher tax scale if you convert all your IRA. It is important that you stay out of the higher tax bracket.
There are some naysayers that don’t promote the Roth Conversion. I appreciate their voice, because like with most personal finance planning there may be several different approaches and rationales for how something should and should not be done. To be academically honest, various voices should be heard and given an opportunity to weigh-in. In my opinion, I don’t blindly believe in or against this strategy of converting IRA funds into a Roth IRA, it comes down to each individual’s situation, goals and plan. If it makes sense, then there may be a case to consider it as an option. As a whole, once you do the evaluation of the Roth conversion, if the power of the benefits is realized then it should be at least be on the table and evaluated with an open mind.