The Pros and Cons of Roth IRA Conversions

The Pros and Cons of Roth IRA Conversions

March 25, 2024

Do you believe you have more money in your Traditional IRA and 401(k) plan accounts than you'll really need to live on during retirement? Are you worried that required withdrawals could move you into an undesirable tax bracket? Would you like to leave as much of your retirement nest egg as possible to your heirs?  

If you answered "yes" to at least two of these questions, you might want to consider moving some or all of your retirement assets into a Roth IRA, once you've spoken to a tax professional or financial advisor to help you weigh the potential benefits and risks of this strategy.

The Roth tax-free advantage

Traditional IRAs and employer retirement plans require you to take a Required Minimum Distribution (RMD) every year starting at age 73. (This age will rise to 75 in 2033).

RMDs are taxed as ordinary income. Roth IRAs do not require you to take RMDs. Furthermore, you’ll never have to pay taxes on Roth IRA distributions once you’ve turned 59½ and have owned the account for at least five years.

Converting from other retirement accounts to a Roth IRA will enable you to avoid future RMDs--at the price of having to take a tax hit today. 

The conversion process

You can't directly fund a Roth IRA with distributions from a pre-tax 401(k) plan account. First, you need to do a direct transfer of assets from your 401(k) into a Traditional IRA you already own or establish a separate Rollover IRA. Then you withdraw money from the IRA to fund a Roth IRA. These withdrawals count as taxable income for the year. 

Unlike regular contributions to IRAs, which are capped at $7,000 per year ($8,000 if you're over age 50), you can convert as much of the money in your Traditional or Rollover IRA as you want. 

When does converting make sense?

Considering that you will have to pay taxes when you withdraw money from a Traditional IRA, moving this money into a Roth IRA often makes sense in situations where:

  • You’ve recently retired and your annual income is low enough that withdrawals you make from a Traditional IRA to fund a Roth IRA won’t create a significant tax burden.
  • You plan on working past age 73 and are concerned that additional income from RMDs could move you into a higher tax bracket. (Note: You can choose not to take RMDs from your 401(k) plan account with your current employer even if you're only working for them part-time. However, you will need to take RMDs from Traditional IRAs and 401(k) accounts still with former employers.) 
  • You don’t really need your retirement assets to live on and would prefer your heirs to inherit them with minimal tax consequences.

This last point bears further examination. If your adult children or other non-spouse beneficiaries inherit your Traditional IRA or 401(k) plan accounts, they must fully deplete the assets in these accounts within ten years of your death. Because distributions from these accounts are taxable, this could create significant tax burdens for them.

While assets in inherited Roth IRA accounts must also be fully depleted within 10 years, beneficiaries won’t have to pay taxes on these distributions.

Things to consider before you convert

You don't want the amount of IRA distributions you use to fund a Roth IRA to move you into a higher tax bracket. And it's generally better to pay the taxes you owe from cash in your bank or taxable investment accounts, rather than from the distributions themselves.

If you're approaching retirement and are still earning significant income, there could be other tax implications.  

Here’s an example. Let’s say you and your spouse are both 68 years old and are still working but are enrolled in Medicare because you're not covered by your employer's healthcare plan. Your combined wages plus income from taxable investments result in a Modified Adjusted Gross Income (MAGI) as a married couple of $150,000.  

In 2024, you withdraw $70,000 from your Rollover IRA to fund a Roth IRA. This elevates your combined total MAGI for the year to $220,000. 

Not only could this withdrawal move you into a higher federal tax bracket, but, since your combined MAGI is higher than $206,000 it could also increase Medicare premiums for both you and your spouse by $69.90 every month. 

As you can see, converting some or all of your IRA assets to a Roth IRA is rarely a clear-cut decision. That’s why it’s important to consult your accountant or tax professional before you act. If you have a financial advisor you may want to bring them into the discussion as well.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax professional and/or a financial advisor.

*You can only move 401(k) plan or either employer retirement plan assets into an IRA when you’ve left the company and are no longer actively participating in the plan.

This article was authored by Joelle Spear and Jeffrey Briskin. Joelle is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at 508.598.1082 or jspear@canbyfinancial.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.

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