Should You Do a Roth Conversion?

The 2017 Tax Cuts and Jobs Act (TCJA) changed several tax laws. These changes make tax planning an even more critical part of your comprehensive financial plan. 

One of the changes that require more forward-thinking than before is that Roth Conversions are now permanent, not reversible as they have been in years past. Let’s talk about what a Roth Conversion is, and whether or not you should leverage this strategy before the December 31st deadline this year.  

What is a Roth Conversion?

A Roth Conversion is a means of moving Traditional IRA funds and investments to a Roth IRA in a given year. Essentially, funds that you have contributed pre-tax to a Traditional IRA can be rolled over to a Roth IRA once a year. During this conversion, you will pay ordinary income tax on the funds being transferred from your Traditional IRA. 

What Are the Benefits of a Roth Conversion?

The funds that you convert from your Traditional IRA to your Roth IRA are taxed based on your income in the year when the conversion takes place. Then, once they are transferred, those funds grow tax-free in your Roth IRA. They aren’t subject to Required Minimum Distributions, either. 

For taxpayers who have amassed a large amount in their Traditional IRA due to contributions and rollovers, moving funds into a Roth IRA may reduce the amount of their Required Minimum Distributions, which may reduce their overall tax rates once they reach age 70 ½.

Given the current lower income tax rates, converting your funds to a Roth IRA now rather than in future years could potentially save you a considerable amount of money in long-term taxes on the future retirement income that you’ll pull from the Traditional IRA.  It may be time to strike while the iron is hot!

You may be asking:

If Roth IRAs have so many benefits, why wouldn’t I contribute there in the first place instead of rolling funds over from my Traditional IRA?

Although Roth IRAs have many tax benefits, they also have an income limit for contributors. In 2019, you can only have a $122,000 MAGI as a single filer before contribution ability begins phasing out. If you’re a married couple filing jointly, your household MAGI must be under $193,000 in order to contribute the full annual amount to your Roth IRA. 

However, a Roth Conversion is a legal way to take advantage of the tax benefits of a Roth even if you make over the income limit. The Roth Conversion is not a “Backdoor Roth”, which is another way to move funds to a Roth IRA.  It is done by contributing funds to a Traditional IRA that are not tax deductible and converting them annually. You’re effectively taking advantage of a Roth IRA’s tax benefits - even if your income has limited your opportunity to contribute directly.

Considerations and Potential Drawbacks

Although a Roth Conversion can be right for many people, it’s important to look at your unique situation before making the leap. Your primary consideration should be whether or not the conversion will bump you to a higher income tax bracket in the year completed. For planning purposes, it’s best to evaluate late in the year, when most of your tax items are known. 

Because funds in a Traditional IRA are contributed pre-tax, when you perform your conversion, the money you’re moving will be counted toward your adjusted gross income (AGI). Many tax deductions are based on AGI limits, so be sure you are aware of the impact of increasing this amount on your overall tax return.

A few other considerations might be:

1. Capital Gains tax rate.  In some cases, Long Term Capital Gains are not taxed.  Increasing AGI with a Roth Conversion may increase this rate to 15% which could add a significant amount to your tax bill.
2. Social Security income. If your Roth Conversion increases your ordinary income and changes your income tax bracket as a result, more of your Social Security benefits may be subject to tax.  This cash flow hit may not be sustainable for many retirees.
3. Qualified Business Income Deduction. Business owners will have to look at the impact a conversion may have on their 20% Qualified Business Income Deduction. If your income in the year the conversion is performed is on the threshold of the deduction limit, a Roth Conversion may tip you over the edge and disqualify you from QBI benefits.  Conversely, it may also increase the QBI deduction if the Roth Conversion increases taxable income above the QBI. This is complex and would be best evaluated by your tax professional.
4. Medicare Income-Related Monthly Adjustment Amount (IRMAA). When your household income is already above average, you may be subject to IRMAA. This is a higher premium that impacts high-income earners for Medicare Part B and D. If you currently have IRMAA premiums, a Roth Conversion could potentially increase your monthly payments. If your income is on the threshold of qualifying for IRMAA treatment, a Roth Conversion could force you to start paying premiums as a percentage of your higher income. There is a two-year look-back that determines IRMAA. So, even if you perform a Roth Conversion in 2019, you may not see the impact until 2021. This requires forward-thinking and tax planning to ensure you’re protected against higher premiums. 
5.  The Child Tax Credit. Due to the Child Tax Credit increasing to $2,000, the cost of a Roth Conversion may be lower for your family. The credit is taken directly from owed taxes, so you may be able to perform the Roth Conversion at a minimal cost if you also are taking the Child Tax Credit - since the two will (ideally) balance each other out.
6. Alimony. Remember that alimony is no longer a tax deduction, or includable in income statements. Depending on your situation, this could either positively or negatively impact your ability to perform a Roth Conversion at a minimal cost.

Is a Roth Conversion Right For You?

Moving funds from a Traditional IRA to a Roth IRA has many tax benefits, and you may want to consider leveraging this strategy in 2019 or future years. To determine whether or not a Roth Conversion is the right move for you, ask yourself a few questions:

1. Will a Roth Conversion increase my taxable income and move me to a higher, less favorable income tax rate?
2. How will my increased income tax bracket impact my other income, health care, or investments?
3. Did I have any changes in income this year (or last year) that might impact my deductions?
4. Do I have external funds to pay the taxes on my Roth Conversion to gain the most long-term financial benefit? 

Although Roth Conversions can be complex, and they require more planning than they have in previous years, they may still be beneficial for your unique situation. The key is to determine whether the benefits gained from a Roth Conversion outweigh the potential increased income tax bracket. Since this a permanent election, it’s important that you have all of the pieces in place, so it’s advisable to consult a tax advisor.  

Keep in mind that Roth Conversions don’t need to be all-or-nothing. You can convert a portion of your Traditional IRA over the course of a number of years in order to stay within a favorable income tax bracket while still reaping the benefits of a Roth Conversion. 

Need Help?

Remember, your Roth Conversion must be complete by December 31st. If you need guidance, we would be more than happy to assist you. Contact us today for more information. 

Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs, and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.

"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.