Determining if a Roth Conversion is Right for You

First Republic Investment Management, Advanced Planning
May 29, 2020

This article was featured in our Summer 2020 issue of Spectrum which can be viewed in full here.

The current downturn in the stock market has made many investors uneasy. But with market volatility comes opportunity too. Strategic investors know that history tells us stocks are likely to recover, and making smart moves now — like converting a traditional IRA to a Roth IRA — can bring significant tax benefits.

With market values depressed and federal tax rates at a historical low (at least for now),[1] Roth conversions appear to be a wise tax planning strategy. Still, there are factors to consider when determining whether a Roth conversion is right for you.

The differences between traditional and Roth IRAs

The main differences are:

  • Contributions: Those made to traditional IRAs may be tax-deductible, while contributions to Roth IRAs are made on an after-tax basis. Both are subject to limitations.[2] Contributions may be made to both types of IRAs at any age, provided an investor has earned income.
  • Distributions: Investors must take required minimum distributions (RMDs) from their traditional IRAs no later than April 1 following the year they turn 72.[3] Those distributions are taxable. There are no RMDs for Roth IRAs, and qualified withdrawals are tax-free.

What is a Roth conversion?

A Roth conversion is when an investor transfers (or converts) money from a traditional IRA to a Roth IRA. A conversion is considered a distribution, and thus the amount converted is taxed at the investor’s ordinary income tax rate in the year of conversion. The 10% penalty will not be assessed if the investor is under age 59 1/2 as long as the taxes owed on the converted amount are paid with non-IRA assets.

Example: A 40-year-old investor has pre-tax funds of $100,000 in a traditional IRA and is in the 24% tax bracket. The investor decides to convert the entire amount to a Roth IRA and pays $24,000 in federal income taxes with funds in a taxable account. Twenty years later, when the account is worth $300,000, if the investor withdraws all of it, no tax will be due since this is a qualified distribution.

On the other hand, if any part of the IRA contains nondeductible contributions, only a portion of the converted amount will be taxable.

Example: The same situation as above, except $60,000 of the $100,000 consists of nondeductible (after-tax) contributions. In this case, the investor will pay $9,600 in federal income taxes.[4] The $60,000 is considered basis and isn’t taxable when it’s converted to a Roth IRA.

In addition, an investor can choose to convert smaller amounts over several years and stay within their current tax bracket while reducing the size of their traditional IRA. By converting smaller amounts, the investor is making smaller tax payments over time rather than making a substantial one-time tax payment.

Considerations for a backdoor Roth conversion

If the investor already has an IRA with pre-tax dollars, that IRA will be aggregated together with any new nondeductible contributions when the conversion occurs. An investor cannot convert just the nondeductible contributions, regardless of whether the contributions were made to the existing IRA or a new account. Instead, the conversion is subject to the IRA aggregation rule, and the tax consequences are determined on a pro rata basis across all the accounts. Due to the IRA aggregation rule, having an IRA (including SEP- and SIMPLE IRAS) with pre-tax funds has effectively eliminated the investor’s ability to engage in a tax-free backdoor Roth conversion.

Example: The investor has $100,000 of pre-tax dollars in a traditional IRA and is in the 24% tax bracket. The investor’s income exceeds the threshold to establish a Roth IRA, and therefore the investor decides to make a $6,000 nondeductible contribution to a new traditional IRA, then convert it to a Roth IRA. The conversion of the new IRA will be treated as $340 of after-tax funds and $5,660 of pre-tax funds that are taxable as a result of the conversion.[5]

An important exception to the aggregation rule is that it doesn’t apply to qualified retirement plans, such as 401(k) plans. It’s possible to move only pre-tax funds from an IRA to a 401(k), leaving only after-tax funds in the IRA and thus reducing or eliminating the tax on a Roth conversion. Such a transfer is only possible if the plan allows it. Review the plan document or check with the plan administrator before acting.

Roth conversion considerations

Deciding whether to convert a traditional IRA to a Roth IRA requires careful consideration of several factors. Investors should talk with their tax advisors to evaluate their own financial circumstances.

  • Future asset appreciation: If an IRA is depressed in value relative to its future appreciation potential, converting earlier in the year may make sense.

  • Current and future taxable income or tax rates: If an investor expects their taxable income or tax rates to decrease in the future, converting a traditional IRA to a Roth IRA may not make sense, as the investor would pay income tax on the converted amount at a higher rate.

  • Taxes due on conversion: If the IRA to be converted has substantial nondeductible contributions, there may be minimal tax due on the conversion.

  • Taxable funds to pay the taxes on the conversion: Using funds from a converted IRA to pay taxes means there will be less money in the Roth IRA to grow tax-free. When possible, taxes should be paid with funds from a taxable account.

  • Losses or deductions could offset income from the conversion: Making a charitable contribution or having a charitable contribution carryover (or other deduction) may offset all or some of the income recognized on the conversion.

  • Reduced income in the year of conversion could make taxes more palatable: The CARES Act waived RMDs from retirement accounts in 2020. Converting an amount equal to the RMD will place an investor in a similar tax situation, as though the RMD hadn’t been waived. Likewise, deferring income to a later year and converting an amount equal to the income deferred will place an investor in a comparable tax situation.

  • Disqualification for various tax benefits: The income from a full conversion could push an investor into a higher tax bracket, phase out deductions or credits, or disqualify the investor for other means-tested benefits.

  • Time left until retirement: An investor who is close to retirement has less time to make up for what was lost to taxes on the conversion.

When done thoughtfully, a Roth conversion can be a powerful tax planning tool that can provide tax-free income to a family for years to come. In the current moment, with lower account values and historically low tax rates, this could be an ideal time to convert a traditional IRA to a Roth IRA. However, investors should fully review the tax consequences and other considerations to help determine whether a conversion is suitable.

First Republic can work with you and your tax professionals to help you weigh all the options and help guide you through the decision-making process.

 

 



[1] States have different laws regarding which income is taxable and nontaxable. Given the myriad rules, this article doesn’t account for state income taxes.

[2] For example, a married couple filing a joint return may not contribute to a Roth IRA if their modified adjusted gross income is equal to or greater than $206,000.

[3] The SECURE Act changed the age requirement of RMDs from 70 1/2 to 72.

[4] The calculation is ($100,000 – $60,000) x 24%.

[5] The calculation is Total Nondeductible Contributions Converted x (Total Nondeductible Contributions Converted / Total of All IRAs), or $6,000 x ($6,000 / $106,000).

 

First Republic Private Wealth Management encompasses First Republic Investment Management, Inc., an SEC-registered Investment Advisor, First Republic Securities Company, LLC, Member FINRA/SIPC, First Republic Trust Company, First Republic Trust Company of Delaware LLC and First Republic Trust Company of Wyoming LLC.

The strategies mentioned in this article may have tax and legal consequences; therefore, you should consult your own attorneys and/or tax advisors to understand the tax and legal consequences of any strategies mentioned in this document. This information is governed by our Terms and Conditions of Use

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