The answer depends on many factors including the characteristics of income each year.
The Roth IRA is certainly worthy of its part in a well-rounded retirement plan and as a main component of The New Three Legged-Stool. Although there are many rules restricting the funds that can make their way into (and then out of) a Roth IRA, once the requirements have been satisfied most investors would agree that their Roth IRAs have become their favorite type of retirement account. This may have something to do with the tax-free growth. By providing the option to access funds without creating a taxable event, this type of retirement account allows for more control over taxes each year.
The value of this option leads clients and their financial planners to try to maximize the Roth IRA’s potential by building the account balance via contributions and by conversions of traditional IRA balances in a tax-efficient way. There are income restrictions that can block a working client from making an annual contribution (up to $5,500 in 2016, plus $1,000 catch-up contribution for those age 50 and older with earned income); however, there is currently no limit on the amount that can be converted from a traditional IRA to a Roth IRA, provided the amount is reported on the tax return for the year of conversion.
A common and recurring question among clients is then: does it make sense to convert to a Roth and pay an additional tax this year? The answer depends on many factors including individual circumstances and the characteristics of their income each year.
Typically, a Roth conversion makes sense if you expect to be in a higher tax bracket in the future, there are non-retirement funds available to pay the increased tax, and the account is expected to exist for a relatively long time. These conditions provide a good environment to recover the expense of converting (the additional tax) with tax-free growth over time.
While those circumstances are helpful, there are still other factors to consider before converting to a Roth IRA. One of the surprises for clients is that the increase in taxable income due to the conversion could increase the amount of tax due on certain other types of income common among retirees, including Social Security benefits and investment income. This tax increase on those types of income would be in addition to the tax due on the conversion amount itself. Also, certain tax credits could also become reduced due to the higher taxable income.
It can then be helpful to gauge the cost of a Roth conversion in terms of the overall change in tax due with and without the conversion for a particular tax year. This allows us to capture all of the changes that the conversion effects. Common areas on the tax return that can be affected are: taxable Social Security benefits, medical deductions and other income-based itemized deductions, and certain dividend and capital gain investment income.
For example, many retirees are familiar with the fact that up to 85% of Social Security benefits can be taxable. The amount that is taxed is tied to “Modified Adjusted Gross Income,” which includes any amount converted from a traditional IRA to a Roth IRA. If a client is collecting Social Security benefits and is not already at the full 85%, then a conversion would very likely increase the amount of taxed benefits.
Similarly, many retirees have investment income as part of their retirement plan. This income includes qualified dividends (income paid from investments held 60 days or longer) and long-term capital gains (profits from sales of investment held longer than one year). These two types of income are taxed at special rates of 0%, 15%, or 20%, depending on the tax bracket. Clients who are able to enjoy the 0% rate on this income could see the conversion “push” a corresponding amount to the 15% rate.
Finally, increasing taxable income from a Roth conversion could also erode or eliminate any income-related tax credits that otherwise would have been received. Tax credits for higher education expenses and healthcare subsidies are both phased-out at certain income levels.
Each new tax year could provide a great opportunity to convert funds from a traditional IRA to a Roth IRA, but the decision can involve many moving parts and should be evaluated carefully. A great first step is to look at the tax liability for all other sources of income and compare the change in refund or tax due to the amount of the conversion. From there, the client and planner will have a good idea of the cost of the conversion for their comparison to future years.
- Elements of Successful Roth Conversions: lower tax bracket now, the account will exist for a long time (owner plus any beneficiaries), non-retirement funds available to pay the related tax.
- Each year, the total change in tax due with and without a Roth conversion can tell us the combined cost in terms of any changes to taxable Social Security benefits, investment income, and deductions.
- Tax Credits and Healthcare assistance could also be affected.