Do Your Homework Before Considering a Roth IRA Conversion

There’s been a great deal of media focus on retirement accounts lately — specifically, Roth IRAs. There are several reasons for this, one being the news of PayPal co-founder Peter Thiel having a Roth IRA worth over $5 billion. But the primary reason for the renewed interest is President Biden’s proposed American Families Plan. This plan seeks to implement a wide range of tax updates, with particular attention paid to retirement accounts. Such changes include: 

• Prohibiting all Roth conversions for those in the top income tax bracket. (But only after a 10-year window; a move actually encourages high-income taxpayers to convert to Roth accounts and pay the associated taxes while they can).
• Prohibiting Roth IRA conversions of after-tax funds in retirement accounts altogether, beginning in 2022 (therefore ending the “backdoor” Roth)
• Forcing required minimum distributions (RMDs) for IRAs with a combined balance of over $10 million, regardless of age — a move designed specifically to force dollars out of large retirement accounts.

For a better understanding of what all that means, let’s take a closer look at Roth conversions. 

What is a Roth conversion?

Simply put, a Roth conversion is the process of moving money from a traditional retirement account into a Roth account, and paying tax in the process. Investors generally make the decision to convert if their current tax rate is lower than their expected tax rate in retirement (and therefore more money is saved because less taxes are paid). 

The primary attraction of a Roth IRA is that it allows for potentially tax-free withdrawals since the contributions are made with after-tax money. Taxes are paid today, not later. That’s unlike a traditional IRA, where you make before-tax contributions that provide a tax deduction today, but require those taxes to be paid later on withdrawals. This obviously has implications if an investor expects to be in a higher income tax rate in the future.

Another key factor is, unlike a traditional IRA which requires RMDs, a Roth IRA doesn’t require distributions during the life of the original owner. That means the money grows tax-free for as long as they want. Contributing to a Roth IRA won’t lower an investor's taxable income, but they also won’t have to pay taxes on withdrawals from earnings provided they're over 59½ and have had the account open for five years or more. 

The advantages

If you’re likely to be in a higher tax bracket in retirement than you’re in now, the tax-free withdrawals of a Roth IRA are attractive. And if taking a required minimum distribution from a traditional IRA could push you into a higher tax bracket, it may make good sense to shift funds to a Roth – especially considering that this higher bracket could subject a larger portion of your Social Security income to taxes or increase Medicare premiums.

A Roth IRA can also provide tax advantages for your heirs. With the enactment of the “Setting Every Community Up for Retirement Enhancement” (SECURE) Act in 2019, stretch IRAs for beneficiaries were all but eliminated. These beneficiaries are now required to draw down an inherited IRA within 10 years rather than over a lifetime. These distributions from an inherited IRA would be considered taxable income, but the distributions from an inherited Roth IRA would generally be tax-free.

A few other considerations

All of that being said, we need to keep a few things in mind. Since you’re paying income tax on any amounts transferred out of a traditional IRA, you need to ensure that you have the money on hand to pay those taxes. If you expect to be in a lower tax bracket in the future – whether due to retirement, a spouse leaving a job, or any of a host of reasons – it may make more sense to wait on undertaking a Roth conversion until then.

In addition, penalties may be owed on distributions within five years of the conversions. It’s also important to remember that Roth IRA conversions can’t be reversed meaning the assets can’t be converted back into a traditional IRA. So do your homework and plan wisely.

Don’t take a chance, talk to an expert

There are many potential long-term advantages to a Roth conversion. With potential tax changes, there’s no time like the present to examine your portfolio and determine what makes the most sense for you. Remember, there are several factors to consider and tax planning is a complex and nuanced process. So be sure to consult a tax professional before making any decisions with the power to impact your financial future.

Hunter Yarbrough is an executive vice president and financial adviser with CapWealth. For more information about Hunter and CapWealth, visit capwealthgroup.com.