Should You Convert Your IRA to a Roth?

06.30.2021 - Nicole Bennett Price, Senior Trust Officer

Who wouldn’t love to have 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, 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?

Depending on how you answer these questions, your decision on whether to convert could be relatively straightforward or just a bit more complicated.

If you will need to tap into your IRA to pay the tax on the conversion, and you think your tax rate on the IRA distributions will be the same or lower in the future, there’s no benefit to converting. For example, assume the cost of converting your $1 million IRA now is $300,000, and you make that payment from your IRA. This is a 30% effective tax rate. So, unless you think your tax rate on future distributions will be more than 30%, there’s no benefit to convert. 

In contrast, assume you pay the tax with funds from other accounts, such as your savings or investment accounts, and you also think your tax rate on future distributions will be the same or higher than it is today. In that case, it generally will make sense to do the conversion. For example, if your tax cost is $300,000 now and it would be the same or even higher in the future, converting has definite benefits. You would still have $1 million growing tax-free within your new Roth IRA. And you would lock in the taxes at the current rate, which is lower than the rate you anticipate in the future.

In this example, your balance sheet would appear to be down $300,000. But that’s because you probably aren’t considering the tax cost attached to your IRA before a conversion. In reality, that tax cost is a liability on your balance sheet. And it’s growing at the same rate as your IRA—faster if your tax rates increase. By converting, you pay off that liability before it has potential to grow. 

What if Your Answers Are Not So Clear?

Your situation might not be so straightforward. Like many people, you may think your tax rates will be lower by the time you start withdrawing retirement assets, but you still want to do the conversion. You might even find non-IRA assets to pay the tax if you saw the potential for long-term savings. On the other hand, you might not be so sure your tax rates will be lower in the future, but you are clearly able to pay the taxes with funds from outside your IRA.

In these situations and others with multiple factors weighing in, the key is to run the numbers.

There is a wide range of factors to consider:

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 Required Minimum Distributions and Social Security withdrawals. Also consider the prospect of higher tax rates in the future under the new administration and the scheduled expiration of many individual tax cuts in 2025.

2. When you plan to take distributions

The longer your IRA has to grow, the more benefit you’ll have from a conversion. This applies to the timeframe before you start to take distributions. It also applies to how long you’ll take distributions after you start. Converting when you’re young tends to make the most sense. But converting when you’re older also can be worthwhile if you plan to defer distributions or other factors line up to support that decision.

3. Market movements

It can be a good idea to convert your traditional IRA to a Roth when its value declines. You’ll pay a tax based on a lower value 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 Act, your beneficiaries typically will need to withdraw 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 it also 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. However, for those charitably inclined, there also are situations where a Roth conversion can make particularly good sense. Special tax rules in 2021 allow you to offset 100% of your income for cash contributions to a public charity (other than a donor-advised fund) or a private operating foundation. This means you can give a potentially higher amount to charity this year to help offset the income tax hit from the conversion.

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. While the federal estate tax exemption is $11.7 million per person (or $23.4 million for couples) in 2021, those exemption amounts are set to be cut in half in 2026 and may decrease sooner, and to greater extent, under the new administration in Washington.

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.

Converting a traditional IRA to a Roth is an attractive idea for many, especially as they take stock of their finances each year. 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.   


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