As the end of the year approaches, retirement planning often shifts from long-term goals to more immediate tax and income considerations. One strategy that may come up during a year-end financial review is a Roth conversion.
A Roth conversion involves moving money from a traditional IRA into a Roth IRA. While the strategy can offer potential long-term tax benefits, the conversion may also create a current-year tax liability. Understanding how the strategy works—and what factors should be considered—can help investors determine whether it warrants further discussion with their financial and tax professionals.
What Is a Roth Conversion?
A Roth conversion allows an investor to transfer assets from a traditional IRA to a Roth IRA. The amount converted that would otherwise be taxable from the traditional IRA is generally included in the investor's taxable income for the year of the conversion.
For example, suppose an investor has $50,000 in a traditional IRA and decides to convert $20,000 to a Roth IRA. Assuming the converted amount consists entirely of pre-tax funds, that $20,000 would generally be included in the investor's taxable income for the year.
The investor doesn't necessarily have to convert the entire traditional IRA. A conversion can involve only a portion of the account, which may allow investors to consider how much additional taxable income they want to recognize in a particular year.
Why Consider a Conversion at Year-End?
One potential reason to consider a Roth conversion is to pay taxes on retirement assets today in exchange for the possibility of tax-free qualified distributions from the Roth IRA in the future.
Roth IRA contributions are not deductible, but qualified Roth IRA distributions generally aren't included in taxable income. In addition, Roth IRA owners are not required to take minimum distributions during their lifetime under current federal rules.
The tax treatment can make Roth conversions worth evaluating when an investor expects their current tax situation to be different from their future tax situation.
Year-end can also be a useful time to review a conversion because investors may have a clearer picture of their income for the year. Wages, bonuses, investment income, charitable giving, retirement contributions, and other factors can all affect the overall tax picture.
The Tax Impact Matters
The biggest consideration with a Roth conversion is often the tax bill.
Converting too much in a single year could increase taxable income enough to push some income into a higher marginal tax bracket. The additional income could also affect other tax-related items, depending on an individual's circumstances.
That's why a Roth conversion isn't simply a question of "Should I convert?" It can also be a question of "How much should I consider converting?"
Some investors may consider partial conversions over multiple years rather than converting a large amount at once. The appropriate approach depends on the individual's income, tax situation, retirement objectives, and other financial circumstances.
Don't Forget the Five-Year Rules
Roth IRAs have specific rules governing when distributions can be considered qualified.
Generally, qualified Roth IRA distributions must satisfy a five-year requirement and one of several additional conditions, such as the account owner being at least age 59½.
There is also a separate five-year rule that can apply to amounts converted from a traditional IRA to a Roth IRA. Each conversion can have its own five-year period for purposes of the additional tax rules on certain early distributions.
For investors who may need access to their retirement funds before retirement age, these rules are important to understand before completing a conversion.
Other Factors to Consider
A Roth conversion should be evaluated as part of an individual's broader financial picture. Depending on the circumstances, considerations may include:
- Current and future tax rates: What is your current marginal tax rate, and how might your taxable income change in retirement?
- Amount converted: Converting a portion of an IRA may produce a different tax result than converting the entire account.
- Source of the taxes: Investors should consider how they will pay the resulting tax liability. Using retirement assets to pay the tax can reduce the amount ultimately transferred to the Roth IRA.
- Existing IRA basis: If you have made nondeductible contributions to traditional IRAs, the tax calculation can be more complicated.
- Future retirement income: Social Security, pensions, investment income, and required distributions can all affect future taxable income.
- Estate and legacy considerations: Roth assets can have different tax characteristics for beneficiaries than traditional IRA assets.
- Timing: A conversion generally counts toward the tax year in which it occurs, making year-end an important deadline to keep in mind.
Because tax rules can be complex, investors should consider consulting with a qualified tax professional before completing a conversion.
A Roth Conversion Isn't Automatically the Right Choice
A Roth conversion can be a valuable retirement-planning tool, but it isn't universally appropriate.
Paying additional taxes today may or may not make sense depending on an investor's current tax bracket, expected future income, retirement timeline, available cash to pay the tax, and other factors. A strategy that makes sense for one household may not make sense for another.
The goal isn't simply to minimize taxes today. It's to understand how today's tax decision fits into the larger retirement plan.