When and Why You Should Convert an IRA to a Roth

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The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the ability to use recharacterization to reverse the conversion of a Traditional IRA into a Roth IRA. The process of undoing a Roth conversion was called a “Roth recharacterization.” This rule existed because tax payers often did not know what their total income would be until after the end of the tax year. A recharacterization allowed you to put the money back into an IRA without paying tax or penalty. The Roth conversion was treated as though it never happened. TCJA has eliminated this rule starting in 2018. All conversions are now final when made.

Converting an IRA to a Roth creates a taxable event on any amount of pretax money in the IRA. The tax is paid in the year of conversion, resulting in all the earnings growing tax free from that point on (providing the rules are followed). You wouldn’t be forced to withdraw funds at age 70½ and could subsequently pass the money to your heirs in a more tax-advantageous way. Why do this? Because you don’t have to pay tax on the earnings in your Roth IRA account when you withdraw the money.

Lifting the income limit on conversions opens the door for taxpayers exceeding the income limits for Roth contributions to make them through a two-step process. For 2018, the maximum contributions to a Roth IRA are limited to single taxpayers who make no more than $120,000 in adjusted gross income (AGI), and to couples with a combined AGI of no more than $189,000. Partial contributions can be made for single filers with AGI between $120,000 and $135,000 and for joint filers with AGI between $189,000 and $199,000. Those income limits are indexed for inflation. However, there is no income limit for making non-deductible contributions to a traditional IRA or converting an IRA to a Roth. A taxpayer could make a contribution to an IRA and then convert the entire amount to a Roth IRA.

Should I convert to a Roth IRA?

Now you know the nuts and bolts behind Roth IRA conversions, how do you determine if this strategy is right for you? There’s no easy answer to this question. Ultimately, each person must analyze this option based on his or her individual circumstances.

In general, a conversion may be a good idea if:

  • You don’t plan to touch the money in the Roth for at least the next eight years.
  • You can pay the income taxes due on the conversion without using funds from the traditional IRA when you convert.
  • You expect to be in a higher tax bracket in future years. Paying the taxes now while you’re in a lower income tax bracket could save you income taxes later.
  • You don’t expect to need the Roth IRA assets for income and want to build an estate for your heirs. In this case, the Roth IRA can minimize the overall income tax burden to the family; heirs receive the proceeds free of income taxes, and in the interim, the proceeds can continue growing tax free.
  • You don’t expect to need income from your IRA, and you wish to avoid the annual mandatory distributions required from a traditional IRA when you reach age 70½.
  • You believe current income tax rates are at the lowest level now and Congress will most likely increase tax rates in the years to come.

A conversion is generally a bad idea if:

  • You can’t pay the income taxes due on the conversion without using funds from the traditional IRA. Taking the tax from the conversion assets reduces the amount within the Roth for compounding purposes. An early withdrawal penalty may apply for taking money from a traditional IRA before age 59½.
  • The added income for the year caused by the conversion puts you in a significantly higher tax bracket (to avoid this, you can have your tax adviser calculate the amount of income you can add before moving into the next higher bracket, then only convert the amount that keeps you in your current tax bracket).
  • You expect to be in a lower tax bracket in future years. Paying the taxes later at the lower rate would offset the lack of tax-free growth.
  • You think Congress will adopt a radical change in the tax system whereby income will no longer be taxed. A national sales tax or some form of value added tax has been debated for years. Obviously, it wouldn’t make sense to pay tax on income now if the income tax will be abolished in the future.

Convert to a Roth in Down Markets

The stock market meltdown from 2008 to 2009 caused many investors to lose faith in the financial markets, with good reason: the Dow Jones Industrial Average fell 54% from its peak in October 2007 to its low in March 2009. But for long term investors holding stocks and stock funds in their retirement accounts, this was the perfect opportunity for a Roth conversion.

You’ll have to pay taxes on the money you withdraw from your IRA account someday; what better time than when the market is down, and you can pay tax on the discounted value? This strategy calls for some advance tax planning, so you know how much tax you will owe on a conversion. Then, when the stock market goes into one of its sell-off periods, you’ll be able to convert at the lower account value.

The big advantage of this Roth conversion strategy comes when the market recovers, and the account grows back to its original value, since the account growth from the recovery will be all tax-free! (At least it will be, once you hold the funds for five years and have reached age 59 ½).

Fortunately, 54% drops in the stock market like the one from 2008 to 2009 have been rare. However, 10-20% drops are a more common part of the stock market cycle. So, when you hear the newscasters say “correction”, think “conversion,” since that means the stocks in your IRA are at a discount—and you can take advantage of it.

Still unsure about Roth conversions as a tax strategy? Our financial advisers can evaluate whether a Roth conversion is a viable option for you.

Rick’s Tips:

  • Anyone can convert an IRA to a Roth. There are no income limitations.
  • Before you convert an IRA to a Roth, make sure you know how much it will cost in taxes. You should have the money to pay the taxes in an account outside of the Roth.
  • Amateurs fear stock market corrections and try to time the market to avoid them. They usually end up buying high and selling low. Pros know corrections are part of the stock market’s normal trading pattern and use them to take advantage of opportunities.

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