A Roth Conversion is a transfer of some or all of money in a tax-deferred IRA into a Roth IRA, which is retirement account into which you contribute after-tax dollars and get tax-free withdrawals. This means tax-free growth, indeed difficult to achieve and well worth considering!
When you do a Roth Conversion, you have to pay income tax on the transferred amount. Many experts believe this is a lower tax rate today than will be later because of the 2017 tax rate reductions. This is the crux of the decision, do you believe your current marginal tax rate is higher or lower than the rate you believe you will likely pay in the future?
The fact that asset values currently are reduced combined with the income tax rates creates a very attractive opportunity for many people to consider a Roth Conversion.
Advantages of a Roth Conversion
- Future withdrawals of both the principal and earnings are tax-free and penalty-free, once you have held the converted funds in your Roth for 5 years and are age 59½ or older.
- Roth IRAs are not subject to Required Minimum Distributions.
- Roth funds are a tool to manage timing of income taxes in retirement using withdrawals strategically to stay within a lower tax bracket at preferred times.
Disadvantages of a Roth Conversion
- If you withdraw the converted funds from your Roth prior to the completion of the 5 year holding period, you will likely owe tax on the earnings. If you withdraw prior to age 59½, in addition, you will likely owe a 10% penalty tax on the earnings. There are limited qualified exceptions to the tax and penalty.
- Creates an income tax due for the year in which you do the conversion, instead of deferring that tax liability into the future.
It is most advantageous if the account owner pays the income tax using money outside the IRA, instead of withholding taxes from the IRA, especially if you are under age 59½. For example, if you convert $100,000 and use $25,000 to pay the income taxes, you have paid for a $100,000 conversion but are only receiving $75,000 of value. If you are under age 59½ you will also owe a 10% penalty ($2,500) on the $25,000 you withdrew to pay taxes.
Doing a Roth Conversion is not an all or nothing event. A common strategy is to convert a portion, just enough of your IRA, to make full use of your current income tax bracket for the year, but not go into the next higher bracket.
For retirees, the best time to do a Roth Conversion is before you have to take your Required Minimum Distribution (age 72 or 70½ depending on when you were born). If possible, taking it before drawing Social Security is even more beneficial. This time period is often when your taxable income and the corresponding tax rate are at their lowest.