Your Guide to Roth IRA Conversions

by Sophia Bera on November 23, 2016

If you’ve been reading my blog for awhile, you’re one of my clients, or you took my course, Smart & Easy Retirement Planning for Millennials, you know I talk about Roth IRAs a lot. With a Roth, you contribute up to $5,500 post-tax dollars per year, hopefully it grows for a few decades, and then you can withdraw that money in retirement tax-free.

I recommend them often, especially to people who are in a lower tax bracket now (say, 15% or 25%) and might be in a higher bracket in the future. That’s because you can lock in the lower tax rate today.

However, there are income limits. For 2017, those limits are $133,000 (single) and $196,000 (married). There is a phase-out for Roth IRA contributions as well.

What About Roth Conversions?

I’m frequently asked about Roth conversions, where you convert an IRA or an old 401(k) into a Roth IRA. This is a money move that can make sense in certain situations, and if you’re seriously considering it, talk to a financial planner and accountant about it because it all has to do with your tax situation both now and in the future.

The higher your tax bracket, the more money it costs to convert because you pay the taxes on the money now. You’re basically placing a bet on the fact that you’ll be in a higher tax bracket later on so you’d rather pay the taxes now.

Why Would I Convert My IRA to a Roth IRA?

If this has been a low income year for you (due to unemployment, staying at home to care for family, or switching careers) or you think that your income is going to increase rapidly in the future, then you should seriously consider converting your IRA to a Roth IRA.

You’ve likely funded your IRA or rollover IRA with pre-tax dollars. That money grows tax-deferred and when you withdraw that money in retirement, you’ll pay taxes on it based on your tax bracket in retirement.

Regardless of your income level, you can convert a traditional IRA to a Roth. If you do this, you’ll pay income taxes on the amount you convert, so I recommend having enough money set aside in a savings account to pay the taxes on the amount you’re converting so it doesn’t come out of the amount you’re converting. (I know that forking over money now doesn’t sound appealing but it could save you thousands of dollars if you’re in a much higher tax bracket in the future).

Another benefit a Roth has over a traditional IRA is that you don’t ever have to take your money out. Traditional IRAs have required minimum distributions — you have to take at least the minimum required amount of money out when you turn 70 ½.

There is no such requirement with Roth IRAs, making them ideal to pass onto heirs. Converting a traditional IRA to a Roth can potentially lower your estate taxes, as well. As always, consult a financial planner or estate attorney for guidance in planning your estate.

It Doesn’t Have to Be All or None

Also, you can do a partial conversion. For example, if you have an IRA rollover with $25,000 and you are currently in the 15% tax bracket, but $10,000 away from the 25% tax bracket, you could convert $10,000 from your IRA to your Roth IRA and pay $1,500 in taxes (15% of $10,000), thus filling up the rest of the 15% tax bucket while your tax bracket is low.

(All this talk about tax brackets can be confusing, so here’s this chart of 2016 tax brackets so you can see how close you might be to the next tax bracket).

I think it’s going to be extremely helpful in retirement to have different tax buckets to pull money from: tax-deferred money (like 401(k)s and IRAs), tax-free money (like Roth IRAs), and taxable money (like brokerage accounts). By having all three buckets, you will have more flexibility in the future because you can decide which tax bucket to pull money from each year.

The Conversion Conundrum

Converting retirement accounts to Roth IRAs can be a tricky decision to make. Like so many financial questions, the answer to “should I do a Roth conversion?” is “it depends!” If you think you might be a good candidate, then you should reach out to your tax accountant and see if he or she can run a tax projection before the end of the year and ask about how a Roth conversion might affect your tax situation.

If you’re unsure of what actions to take, I can help walk you through your options and if you decide to become a client, I can connect you with a CPA in my network.