Roth conversions are a hot topic these days. Many people are making or at least considering this financial move, and many publications are writing about it. A quick online search shows dozens of different articles on the ins and outs of Roth conversions from major publications in the past few weeks. Recently, Peter Coy, a columnist for the New York Times, reached out to me and other financial advisors for an article on the vehicle. It’s a solid article, but I have more to say.
Here are my thoughts.
In a regular, non-Roth IRA, account owners do not pay tax on the money they deposit; only on the money they withdraw later, in retirement. In a Roth IRA, the opposite is true — account holders pay tax upon deposit and not withdrawal.
If you’re making regular contributions to a Roth account directly or through your employer, you are paying taxes as you go. It’s gradual. If you’re converting a large IRA or part of it to a Roth all at once, you pay tax on the entire conversion, and you’ll see a much larger tax bill than usual. Understanding that, is it a good idea to convert IRAs to Roth IRAs? If so, when and how much?
As in so many other things, it depends on your situation.
What are the potential advantages of Roth conversions?
Why would you deliberately increase your tax bill? There are a couple of reasons:
- No or lower RMDs: Starting at your age 73, you must take RMDs (required minimum distributions) from your non-Roth retirement accounts and pay taxes on them. Roth accounts do not require RMDs, and Roth distributions are not taxable. This means you will have less taxable income in retirement.
Less taxable income means lower taxes.
- Lower IRMAA: IRMAA (Income-Related Monthly Adjustment Amount) is a monthly Medicare charge for high earners. The higher your taxable income, the higher your IRMAA, and the greater likelihood that you’ll pay a monthly Medicare surcharge. Again, Roth assets instead of non-Roth retirement assets means lower taxable income.
Less taxable income means lower IRMAA.
What would my income be if I didn’t convert to a Roth?
Fundamentally, the question is whether a Roth conversion lowers your lifetime tax and IRMAA costs. The answer will depend critically on your lifespan and on future income tax and IRMAA rates.
We can use our understanding of taxes, retirement, Medicare, and your circumstances, along with excellent financial planning software (MaxiFi) to calculate the present value of your taxes and your IRMAA for many different Roth conversion strategies and select the best one. In particular, you can develop a sense of the impact of lifespan and other factors on the results. Then you can compare the numbers for different strategies and make a well-informed decision.
What’s the best way to pay the conversion tax?
Once you understand the immediate and future tax ramifications of converting some or all your retirement account to a Roth and decide to act, there is also a recommended way to pay the tax.
For this, I’ll use an example. John has an IRA with $100,000 in it and wants to convert the entire account to a Roth. Since he’s in a 25% tax bracket, he’ll have to pay the IRS $25,000 to convert. That’s a big check! John has enough in his savings account to pay the $25,000. If he pays the tax from his retirement account, he’ll have $75,000 in a Roth account and $25,000 in a (taxable) savings account. If he uses his savings to pay the tax, he’ll have $100,000 in his new Roth account. In effect, he has made a (tax-free) $25,000 Roth contribution. Roth account investment income is tax-free.
Is a Roth Conversion Right for Me?
As I mentioned earlier in this article, any major financial decision depends on your individual situation. If you would like to consider a Roth conversion, please contact your financial advisor.