Should you convert your IRA to a Roth?

Like a traditional IRA, a Roth IRA allows your assets to grow tax free. But unlike a traditional IRA, your distributions from a Roth IRA are not subject to tax. In addition, you don’t need to take distributions from a Roth if you don’t want to. In other words, a Roth IRA can simply grow and grow during your lifetime without being diminished by either taxes or distributions.

Sound good? Well, there’s a catch. Converting your traditional IRA to a Roth means these assets will be taxed at your current tax rate. For example, if you have a $1 million IRA, your cost to convert it to a Roth IRA will be the taxes on $1 million of ordinary income. That may be a hefty tax bill, especially if you live in a high-tax state or if you have additional income in the current year.

But the benefits still can be substantial, especially when you consider taxes on your traditional IRA that would otherwise be due when you start taking distributions in retirement.

Answer these two questions first

When deciding whether to convert to a Roth IRA, start by answering these two questions:

• Do you have funds outside your IRA to pay the tax liability?
• Do you think your tax rates will increase or decrease in the future?

How you answer these two questions, along with other factors, will help determine if a Roth IRA conversion is right for you.

If you convert and are deciding how to pay taxes on a Roth conversion, using non-IRA funds is typically the smarter choice. Here’s why:

It preserves retirement savings. Paying taxes with non-IRA funds keeps your retirement accounts intact, allowing more money to grow either tax-deferred (in a traditional IRA) or tax-free (in a Roth IRA). This ensures your retirement nest egg remains as large as possible.

It maximizes long-term growth. By avoiding withdrawals from your IRA, you retain the full potential for compounding growth. Over time, even small differences in your initial balance can lead to substantial gains.

It avoids early withdrawal penalties. If you're under age 59½, using IRA funds to cover taxes could trigger a 10% penalty on top of the income taxes owed. This makes the conversion significantly more expensive.

It increases Roth IRA tax-free potential. Paying taxes with outside funds allows the maximum amount of your traditional IRA to be converted into a Roth IRA. The result? A larger Roth balance that can grow tax-free, providing more flexibility and benefits during retirement.

In contrast, using IRA funds to cover the tax bill can reduce the financial benefits of a Roth conversion. Here’s why:

You’ll have a smaller Roth conversion amount. If part of your IRA goes to pay taxes, less money is left to be converted, limiting your tax-free growth potential.

Opportunity cost. Those funds, if left in the IRA, could continue compounding for your future.

Funding the tax bill with non-IRA money maximizes your Roth conversion’s benefits. It preserves your retirement savings, avoids penalties, and allows the largest possible amount to grow tax-free—making it the most efficient and effective approach.

Example:

Let’s say you want to convert a $1 million traditional IRA to a Roth IRA, and the tax liability is $300,000 (assuming a 30% tax rate). If you withdraw $300,000 from the IRA to pay taxes, only $700,000 is converted. This means less money is available to grow tax-free in the Roth IRA.

By paying the $300,000 tax bill with outside funds, the full $1 million goes into the Roth IRA. Over time, the larger balance will lead to significantly more tax-free growth.

What if your answers are not so clear?

Your situation might be more complex than it seems. Deciding whether to convert all or part of your traditional IRA to a Roth IRA involves evaluating numerous factors.

When faced with scenarios like these, it's essential to crunch the numbers and analyze the specifics. A variety of considerations come into play, including:

1. Your current and future tax brackets

Of course, the lower your tax bracket is the less income tax you will pay when you convert your IRA. If your income fluctuates, consider timing your Roth conversion to a particular year, or years, when you have lower income. If retirement is on the horizon, you may experience a drop in income between the end of employment income and the initiation of IRA distributions and Social Security withdrawals. Be cautious about a Roth IRA conversion pushing you into a higher tax bracket, as this could result in paying a higher tax rate on all your ordinary income.

2. When you plan to take distributions

The longer your Roth IRA has to grow, the more benefit you’ll have from a conversion. This applies to the timeframe before you start to take distributions. Converting when you’re young tends to make the most sense. However, converting later in life can also be beneficial, especially if you plan to defer distributions or prioritize leaving more assets in the Roth IRA for your beneficiaries.

3. Market movements

If a market decline has decreased the value of your IRA account, you’ll have less tax to pay at conversion. It can be a good idea to convert your traditional IRA to a Roth at a point when the value is lower. You’ll pay a tax based on a lower amount and any future appreciation in your Roth IRA won’t be subject to income tax when distributed. A well-timed conversion can compound the benefits of long-term tax savings.

4. Distribution requirements and tax burden for beneficiaries

Although your beneficiaries would be subject to income tax if they inherited a traditional IRA, they would not be subject to the tax if they inherited a Roth. Under the SECURE 2.0 Act, your beneficiaries typically will need to withdraw all of the funds in your IRA within 10 years of your death, with the exception of your spouse, minor children, special needs trusts, and individuals who are chronically ill. This timeline restricts the benefits of a Roth. But the Roth eliminates a significant tax burden for your heirs.

5. Your charitable goals

If the beneficiary of your IRA is charity, converting might be less appealing. This also could be true if your plan is to use your IRA to make qualified charitable distributions during your lifetime.

6. Estate taxes

If your estate will be subject to estate taxes when you die, paying the tax on a Roth conversion now can offer another benefit. The income taxes you pay, while they take money out of your pocket, also reduce the size of your estate. If your estate is large enough, it will essentially be taxed at a discounted rate.

7. Implications for other taxes and benefits

Keep in mind that a conversion increases your income in the current year, which can cause collateral damage. Your Medicare premiums could increase if you’re pushed over the applicable thresholds. Taxes on other forms of income, like Social Security or capital gains, might shift. If the Roth conversion isn’t your only major tax event that year, be sure to take the potential effects of all those events into account.

Consider making partial conversions

A Roth conversion isn’t an “all or nothing” proposition. You might decide to convert only a portion of your traditional IRA or spread out the conversion over a number of years. You can’t undo a Roth conversion like you could in previous years. But you can take it one step at a time. A good strategy is to convert as much as possible each year without being pushed into a higher tax bracket.

If you would like to explore the pros and cons of converting to determine if it makes sense for you, please reach out to us. Fiduciary Trust’s experienced wealth planners can help you review the numbers and make a decision that moves you closer to your financial goals.