Should You Convert to a Roth IRA?
Should you convert to a Roth IRA? We will look at:
- the factors in your decision,
- what it might cost, and
- provide some general guidelines to help you determine if converting to a Roth IRA is a good idea.
The Roth IRA is one of the greatest retirement savings programs ever created. You make after-tax contributions. Your money compounds tax free for your retirement. Contrast this to the old way of doing things. You get a tax deduction for your contributions. Your money grows tax deferred. When you retire and use it for income, 100% of those distributions are taxed.
You can convert your existing IRA to a Roth IRA. This means you pay the taxes today, and the money then grows tax free over time. But should you?
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Factors in Your Decision
Current Taxes vs Future Taxes
Will you pay taxes at a higher rate now or in the future? A young person, early in their career, may pay taxes at lower rates. As earnings grow, your tax rates will increase. It could make sense to convert an IRA at today’s lower tax cost.
If you are already retired, your tax rates may not change much. Required minimum distributions could cause your taxes to increase. Otherwise, you may not see your income increase significantly.
Tax rates could also change. Today, tax rates are very favorable for individuals. But this could change in the future. Making the decision based on this is a gamble that may or may not pay off for you in the long run.
How old are you? A young person has many years for tax free compounding. A retiree faces a more difficult decision. If you are younger than age 72 (when required minimum distributions start), it might be a better choice. You cannot convert your RMD amount. RMD’s also increase your taxable income, making conversions more expensive.
The 5-Year Rule
Will you need the money within the next five years? Every time you do a conversion, it starts a five-year clock. This is when the earnings on the converted amount are tax free. That is the main benefit of the conversion. If you need the money, you will pay income taxes on the growth. The amount you converted will not be taxed if it is withdrawn.
For some retirees, a Roth conversion is a legacy planning tool. You need to determine if you pay a lower tax rate than your children.
How do you determine the tax cost of that Roth conversion? You need to know your taxable income. You can find this information on line 15 of your tax return, it is the last line on the first page. It is your earnings, rent, dividends, and Social Security. From this, you subtract all the allowable deductions. This is your taxable income, and it determines your tax bracket.
Here is an example of an unmarried person with no children. Person 1 has a taxable income of $28,000. They are in the 12% tax bracket. Person 2 has a taxable income of $98,000. They are in the 24% tax bracket. The tax bracket changes when taxable income is more than $40,525. Person 1 can convert $12,525 to a Roth IRA with a 12% federal tax cost. This amounts to $1,503.
If person 2, who has the higher taxable income, converts the same amount, they will pay $3,006.
If you are married, the tax brackets are a little different. Couple 1 has a taxable income of $60,000. Couple 2 has a taxable income of $100,000. The tax rate for a couple 1 is 12%, and they move to the next tax bracket at $81,050. This means they could convert $21,050 at the 12% tax rate. The federal tax for the conversion is $2,526. If couple 2 converted the same amount, their tax cost would be $4,631.
Beware of the Early Withdrawal Penalty.
If you are younger than 59 1/2, consider the early withdrawal penalty. The amount that you convert is not penalized. But, if you use money from your IRA to pay the taxes, you will face a 10% penalty. Here is an example of what we mean. The conversion is $25,000. This person is in the 22% marginal tax bracket, their taxes due on the conversion are $5,500.
They do not have the money to pay the taxes from other sources. They must make an IRA withdrawal to pay the tax bill. To cover the taxes and penalties for the payment, they will have to withdraw $8,088. This creates an extra tax cost of $2,588.
The Tax Cost to Your Beneficiaries
Are you in a lower tax bracket than your kids? When your kids inherit your IRA, they have to take the money out over a 10-year period. To spread this evenly, they need to take one-tenth of the account per year. Here is an example.
The date of death value of your IRA is $600,000 and you have two kids. Each child would get 300,000. One-tenth of the balance is $30,000. One of your children is single. Their taxable income before their distribution is $42,000. Your married child has taxable income of $175,000 before the required distribution. The taxable income after the RMD for the single child is $72,200. For the married child, their taxable income increases to $205,000. Your single child is in the 22% tax bracket and the married child is in the 24% tax bracket. Their incremental tax for the RMD was $6,600 and $7,200, respectively.
If you are in the 12% tax bracket, your family is going to pay a lot less tax!
Required Minimum Distributions
Required minimum distributions affect your taxable income. RMD’s are designed to increase over time. Below is an example of a $600,000 IRA that grows at 6% per year. The required distributions grow each year. Over time, it is going to be more difficult to convert your IRA to a Roth at a lower tax cost. If you can do the conversions before you reach age 72, it removes a significant obstacle.
General Guidelines to Convert to a Roth IRA
Can you pay taxes at 12% or less on the conversion?
If so, it makes a lot of sense. It is hard to imagine seeing individual income tax below this amount anytime in the future. It is possible, but probably not likely. If you have the ability to convert your IRA at the 12% level, it is worth consideration. Once your tax rate goes to 22% or higher, the math is not as favorable.
Is your tax rate lower than your beneficiaries?
If your tax rate is lower than your beneficiaries—especially if it’s later in your life— you may want to consider making a conversion. The goal is to send the government as little as you can. Eventually, someone is going to pay taxes on whatever you have in your IRA. None of us like to pay more taxes and most of us don’t want to pay more taxes.
How old are you?
The younger you are the more a conversion makes sense. Time is a significant factor in the compounding equation. The longer you have, the more a conversion makes sense.
How will Required Minimum Distributions affect your taxes in retirement?
If you have been a good saver and have a large IRA balance, you could be facing a significant tax problem later in life. Converting to a Roth IRA can reduce this burden and keep your tax bill smaller. Remember there are no RMD’s on Roth IRAs.
Do you have a lot of tax deductions that significantly reduce your taxable income?
Here is an example. If you or your spouse enter a nursing home you will have a lot of medical expenses. Some of those costs can create a large tax deduction. This could reduce your taxable income to near zero. You may be able to make Roth conversions at a minimal cost.
The decision to convert your IRA to a Roth IRA requires long-term planning. It affects your tax situation and your kid’s taxes. You want to pay the taxes on these accounts at the lowest rates possible over time. Take a deep look at your numbers to see how a Roth conversion can impact you and your family. If you need help analyzing this, talk to a financial planner.
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About the Author
Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors. He specializes in helping hard working, middle class families plan for retirement.