Why Do A Roth Conversion?

With year-end approaching, our Financial Planning and Wealth Management teams have been busy reviewing and implementing financial planning strategies aimed at helping our clients keep more of their wealth. One of the more common strategies is an IRA to Roth conversion. Well-planned Roth conversions are done with long-term thinking in mind, looking at your whole financial plan over several years. With that perspective, potential advantages of a conversion may come to light. There can be more than one reason to consider a conversion, it all depends on your goals and circumstances. Here are seven reasons to consider a Roth conversion.

1. Take Advantage of Low Tax Rates Today

Converting an IRA to Roth may be tax-free if your income is low or your deductions are high. But zero-cost conversion opportunities are uncommon. Most often, a conversion is taxable at your marginal tax rate. So why volunteer to pay tax today that you don’t have to? You may want to lock in a known tax rate today versus an unknown tax rate later. If you expect your tax rate to be higher in the future, especially for an extended period, it may make sense to convert IRA money to Roth before those higher rates apply.

2. Move Investments to a Tax-Free Environment

Investment earnings (dividends, interest, capital gains) inside an IRA or Roth are not taxed. But money withdrawn from an IRA normally is taxed whereas withdrawals from a Roth IRA are usually tax-free. Doing a conversion means that all your future growth within a Roth can compound tax-free without the liability of income taxes attached to it down the road.

3. Lower the Tax Impact of RMDs

IRAs have required minimum distributions (RMDs), typically resulting in taxable income, whether you need the money from your IRA for living expenses or not. Roth IRAs do not have RMDs during the lifetime of the account owner. When you convert some of your IRA to Roth, you lower your future RMDs, and lower the taxes that would be due on those distributions throughout retirement.

4. Reduce Medicare Premiums

For those on Medicare, Part B and Part D monthly premiums are determined based on your income. Those with higher gross income pay higher premiums under IRMAA, the income-related monthly adjustment amount. Your IRA RMD increases your gross income and can increase this surcharge. If you convert to Roth before the surtax applies, and reduce your RMD, you may also reduce the future surtax.

5. Create Plan Flexibility for the Future

If you have a big expense in retirement and need to tap into your IRA to fund it you could create a large tax liability and even push yourself into a higher tax bracket. This could snowball into an even larger cost if you need to take more money from your IRA to pay the tax on the money you took out in the first place. Converting some of your IRA to Roth means you may have more choice in the future about where to take funds from and gives you some options for income tax management that you might not have with only traditional taxable IRA withdrawals.

6. Ease the Tax Burden for a Survivor

Widows and widowers may face higher tax rates than married couples due to a phenomenon referred to as the “survivor’s penalty”. Converting while both spouses are alive may alleviate some of this burden if it lowers the taxable income from IRA RMDs for the survivor. Our Chief Planning Officer, Ed Jastrem, recently discussed how to prepare for the survivors penalty with CNBC.

7. Benefit Your Heirs

If your heirs inherit your IRA, they will likely owe tax on the distributions they take. They may also be forced to deplete your IRA within 10 years, which could result in a large tax cost during that time. If you want to “pre-pay” the tax as a gift to help the next generation, a conversion while you are alive means they could inherit tax-free Roth money rather than taxable IRA money. Paying the income tax on the conversion yourself may also lower your estate for estate tax purposes.

In Conclusion

Many potential advantages can be created via IRA to Roth conversions, but the strategy is not right for everyone all the time. Converting has a cost and is irrevocable. We also can’t be 100% certain it is the right decision, because there is a lot about the future that is unpredictable. The good news is that conversions do not need to be all-or-none, you can do partial conversions over a series of years or convert in years where other income is low and skip converting when other income is high. With the right financial planning tools and experienced advisors to guide a conversation, we can explore your options in the context of your wants and needs.

*Important Deadline* Heritage Financial clients must have requests for Roth Conversions submitted by December 18th to ensure time for processing before the 12/31 IRS deadline.