Income limitations on conversions of traditional IRAs to Roth IRAs were eliminated in 2010, giving high-income taxpayers their first opportunity to consider this financial tool as part of their overall wealth management strategy.
Because converting from a traditional IRA to a Roth IRA requires consideration of myriad factors, it can be difficult to determine whether it’s the right decision. While we recommend that individuals talk with their tax advisors to evaluate their own financial circumstances, the following questions and answers may help determine if conversion is right for you:
Q: Will your tax bracket drop during retirement?
A: If you expect your taxable income to drop substantially during retirement, then converting from a traditional IRA to a Roth IRA may not make sense as you would be paying income tax on the converted amount at a higher rate. Instead, it would be preferable to let the money grow tax-deferred in the traditional IRA and pay taxes on the required minimum distributions at a lower rate. Conversely, if you think your taxable income will rise during retirement or if you think tax rates will increase, now may be an optimal time to convert.
Q: How much income tax will be due on conversion?
A: If the IRA to be converted has substantial non-deductible contributions, there may be minimal tax due on conversion. However, this result can change if you have other IRA accounts that are funded with deductible contributions, as a pro-rata portion of all IRAs will be treated as having been converted, potentially increasing the tax due on conversion.
Q: Where will the money come from to pay the taxes on the conversion?
A: Taxes are due on the earnings and all pre-tax contributions. Using funds from the converted IRA to pay the tax means there will be less money in the Roth IRA to grow tax-free. In addition, if an owner under age 59½ chooses to use a portion of the distribution to pay for taxes they will pay a 10% penalty. Therefore, it is not recommended that a distribution be taken from the IRA to pay the tax. Instead, taxes should be paid with funds from an outside account. If you cannot pay the entire tax with outside funds, you should make a partial conversion up to an amount that taxes can be paid with outside funds.
Q: Do you have unusual income tax deductions or losses that could offset the income from the conversion?
A: If you have large charitable contribution carry-forwards, you may be able to offset the cost of conversion. Similarly, you may be able to accelerate deductions to the year of the conversion. For example, you could choose to prepay state income taxes in the year of conversion to get the benefit of the deduction in that year or purchase property entitled to current expensing.
Q: Will the IRA be subject to estate tax on your death?
A: If you have a taxable estate, paying taxes on the conversion with non-IRA funds will reduce the size of the estate and its related tax liability.
Q: Will the conversion disqualify you for various tax benefits?
A: The income from the conversion could push you into a higher tax bracket, phase out some of your itemized deductions and exemptions, and disqualify you for other tax benefits. Converting the IRA over a period of years may eliminate or reduce the loss of these benefits.
Q: How much time do you have until retirement?
A: The closer you are to retirement the less time you have to make up for what was lost to taxes on the conversion. Therefore, if you are close to retirement and intend on using your IRA assets to cover your living expenses, you should carefully consider whether you will be worse off converting to a Roth.
Q: Do you plan to spend the Roth IRA during your lifetime or leave it to your heirs?
A: Even if you are close to retirement, if you are planning to leave the Roth IRA to your heirs and expect you’ll live a long time following retirement, you should be able to make up the lost taxes. Moreover, unlike a traditional IRA, you and your spouse will not be required to take minimum required distributions from your Roth IRA. This will allow the account to continue to grow free of tax for as long as you or your spouse are living.
Q: Is a charity the beneficiary of the IRA?
A: If you plan to leave IRA assets on your death to charity, the value of the IRA reduces your taxable estate by the same amount. Under this scenario it would not make sense for you to convert.
Q: Do you think your IRA is likely to appreciate by year-end?
A: If you believe that your IRA is depressed in value relative to its future appreciation potential, converting earlier in the year may make sense. The tax due is based on the value on the date of conversion, and future appreciation earned in the Roth IRA will then be tax-free. If the assets instead depreciate during the year, you may recharacterize the conversion so that tax is not paid on assets that lost value. If you are planning to take a “convert and see what happens” approach, you need to make sure that you make a timely recharacterization.
1 The tax law allows for recharacterizing a Roth IRA back to a traditional IRA. This must be done no later than the filing date (including extensions) for the tax year the conversion occurs. Thus, if you converted in 2014, you will have until October 15, 2015, to recharacterize the conversion.
The strategies mentioned in this document will often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. Client’s tax and legal affairs are their own responsibility. Clients should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this document.