A few years ago, the government loosened the rules for converting a traditional IRA to a Roth IRA (If you aren’t familiar, a traditional IRA works like a 401K: you contribute pre-tax dollars but when you retire and make withdrawals those funds are taxed as income). A Roth IRA is different, you contribute post-tax dollars but withdrawals at retirement are tax-free.
Why do you care?
For one thing, in addition to providing tax-free retirement income, unlike a traditional IRA a Roth IRA has no minimum required distributions, so if you pass the account on to your heirs it can continue to grow tax-free. (Think of it as the inheritance gift that keeps on giving.) Plus, Roth distributions are not included in the income calculations used to determine whether your Social Security benefits are taxable.
So let’s look at two scenarios to determine whether you should convert a traditional IRA to a Roth IRA.
One is a no-brainer. Say you have money you wish to put away for retirement but your income is too high to qualify for contributing to a Roth IRA (if your Modified Adjusted Gross Income is over $131,000 for single filers and over $193,000 for joint filers). Then you can’t contribute to a Roth IRA. But you can contribute post-tax, non-deductible funds to a traditional IRA and then do a “back door” conversion to a Roth IRA. The income threshold does not apply to conversions… so no matter how high your income, you can still contribute to a Roth IRA.
Keep in mind the back door strategy is simple to use when you don’t already have a traditional IRA. That makes the process clean and ensures you won’t owe taxes on your contribution (aside from the tax you already paid on the original income). If you already have a traditional IRA that you funded with deductible contributions, though, the tax benefit might be reduced and figuring out your taxes could be more complicated. Make sure you talk to your tax advisor to ensure you make the right decision for your specific circumstances.
The other scenario is more complicated. Say you have funds in a traditional IRA and are considering converting them to a Roth IRA. When does that make sense?
Converting makes sense under the following basic condition: If the tax you pay today is lower than the tax you would otherwise pay to withdraw funds tomorrow. The challenges lie in 1) calculating how much you will actually pay today, and 2) predicting how much you might pay tomorrow.
The general rule of thumb is that if tomorrow’s tax savings justify today’s costs, then it makes sense to pay now for bigger savings tomorrow.
The first challenge – calculating how much the conversion costs today – is relatively straightforward. A Roth conversion affects your current-year income in several ways. Some are obvious, others are easy to overlook, but all are predictable. Possible results include:
- Converting a regular IRA to a Roth increases regular taxable income, which can push you into higher tax brackets
- Converting accelerates phase-outs for medical and dental expenses, miscellaneous itemized deductions, rental real estate loss allowance, child tax credits, college tax credits, and similar breaks
- Converting can subject more of your Social Security benefits to tax and can cost you certain Medicare benefits as well
- Converting may affect college financial aid decisions
- Recognizing income from a Roth conversion can also subject you to Alternative Minimum Tax
The second challenge – predicting how much tax you will pay tomorrow if you don’t convert – is harder. In fact, if your time horizon is long enough, it’s almost impossible. Think about it this way: When Reagan first became president the top marginal tax rate was 70%, yet when he left office the top marginal rate had dropped to just 28%. If you had converted just before Reagan took office, with plans to take tax-free funds a decade later, you would definitely have regretted that decision.
So should you do?
The answer, of course, is it depends on your individual situation. Except in specific circumstances, choosing to fund a Roth IRA or a traditional IRA – much less deciding whether to make a Roth conversion – is rarely an obvious call.
But it is worth considering, because the difference in the taxes you might someday pay on your retirement income could make a huge difference in the quality of your retirement.