Should You Convert to a Roth IRA?

With the impact of the coronavirus driving stock prices to their lowest levels since the Great Recession of 2008-2009, many people have seen their retirement portfolios significantly decrease in value.

This may create hardships for those who depend on their IRA and 401(k) plan assets to provide income during retirement. But for those who won’t need to rely on this money or plan to pass it on to their children, now might be a good time to consider converting some or all of these assets to a Roth IRA.

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 72 (70½ if you were born before July 1, 1949). RMDs are taxed as ordinary income.

Roth IRAs do not require you to take RMDs. Furthermore, you’ll never have to pay taxes on earnings or withdrawals once you’ve turned 59½ and have owned the account for five years.

But here’s the catch: Normally, to start a new Roth IRA you must have earned income from a job or another source. And if your income is above a certain level you can’t start one.

Converting from other retirement accounts to a Roth IRA—also known as a “back-door Roth IRA”—lets you bypass these restrictions.

When does converting make sense?

Considering that you will have to pay taxes when you withdraw pre-tax contributions and earnings from 401(k) plans* and deductible contributions and earnings from Traditional IRAs, converting to a Roth IRA makes the most sense in situations where:

  • You believe that you will still be receiving significant income from a part-time job or other sources when you retire and you don’t want withdrawals from your IRA to increase your annual tax burden.

  • You’ve recently retired and your annual income is low enough that withdrawals you make from a Traditional IRA or 401(k) plan to establish a Roth IRA won’t create a significant tax burden.

  • You don’t really need your retirement assets and would prefer your children to inherit them with minimal tax consequences.

This last point bears further examination. With the passage of the SECURE Act in 2019, if your adult children or other non-spouse heirs 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 of pre-tax or tax-deductible contributions and tax-deferred earnings from these accounts are taxable, they could create significant tax burdens for your heirs.

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

Why convert now?

If you're thinking about converting some or all of your retirement account assets to a Roth IRA, there are a number of reasons why you may want to start now.

  • If the value of your retirement accounts has dropped significantly this year, converting some or all of these assets to a Roth IRA may generate less of a tax hit than if you do it when your accounts fully recover.

  • If you’re over 70½ and were planning to waive Required Minimum Distributions (RMDs) from your retirement accounts this year under the CARES Act, considering converting the equivalent amount to a back-door Roth IRA. Either way you’ll have to pay taxes but at least converting will let you get a head start on building the value of your Roth IRA.

  • If converting all of your retirement asserts at once would create a big tax burden for you this year, consider converting only some of these assets so you won’t be elevated into a higher tax bracket.

  • If your ultimate goal is to fully move all of your retirement assets to a Roth IRA, considering making partial conversions each year to manage the tax consequences. If you complete the conversion over the next five years, you’ll be able to take advantage of the lower tax rates established by the Tax Cuts and Jobs Act of 2017, which expire at the end of 2025. Keep in mind that if the market rebounds, you may have to take larger distributions later in future years.

A financial advisor can be an invaluable resource in helping you make these very complicated decisions.

Things to consider before you convert

If you’re under age 65, the biggest impact of converting to a Roth IRA will be the taxes you’ll have to pay on the amounts you withdraw from your retirement accounts to fund it. These withdrawals could move you into a higher tax bracket, generating a higher tax bill than you expected.

If you’re 65 or older, there are additional tax considerations to consider:  

  • The amount of the taxable withdrawals could increase your monthly Medicare premiums.

  • The withdrawals could increase your Social Security taxes.

Here’s an example. Let’s say you and your spouse are both 70 years old, are taking Social Security benefits and you’re both enrolled in basic Medicare. In 2020, your joint income from part-time jobs will be $30,000. You withdraw $200,000 from your 401(k) plan in 2020 to start a Roth IRA. As a result, your joint modified adjusted gross income (MAGI) skyrockets to $240,000.

This higher MAGI could increase you and your spouse’s monthly basic Medicare premiums from $144.60 to $289.20. You may also have to pay taxes on up to 85% of your Social Security benefits in addition to regular taxes you’d pay by moving into a higher tax bracket.

That’s why it’s important for anyone considering converting to a Roth IRA to weigh the current tax impact of converting to a Roth IRA versus the future tax-free benefits.

Converting some or all of your retirement 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 your financial advisor manages your retirement assets, you should bring them into the discussion as well to make sure you fully understand the potential benefits and implications of conversion and to guide your through the process.

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 preparer, professional tax advisor, or lawyer.

 

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

 

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This article was written by Joelle Spear, 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 [email protected]

 

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