A few AAII members asked me questions about Roth IRA conversions following the portfolio strategy boot camp I gave a day before our recent Investor Conference. Since some of you may have similar questions, I’m going to discuss some of the things you should take into consideration when deciding to use and/or convert to a Roth IRA.

Roth IRAs have two big advantages: Withdrawals are tax free and there are no required withdrawals. The disadvantage is the requirement for contributions to be made with aftertax dollars. For someone adding new dollars to a Roth account, the full cost of the contribution is borne upfront. (Qualified contributions to a traditional IRA are deductible in the tax year they are made for.) In the case of a Roth IRA conversion, taxes are owed for the calendar year in which assets are withdrawn from a traditional IRA for a Roth IRA. The same rule applies for similar conversions such as a 401(k) to a Roth IRA or a Roth 401(k).

Taxes are a big issue to consider when making a Roth IRA conversion. Roth IRA conversions make the most sense when you anticipate your marginal tax rate being higher in the future than it is now. They make less sense if you anticipate your marginal tax rate being lower in the future. This is the simple rule of thumb for deciding whether to contribute to/convert to a Roth IRA: Pay taxes on withdrawals/conversions at the lower tax rate. The actual decision is more complicated since there are other factors to consider.

One argument for using a Roth IRA is tax diversification. The individual tax cuts incorporated into the Tax Cuts and Jobs Act (TCJA) are expected to gradually become less significant between now and 2025. They will fully expire at the end of 2025 if no new legislation is passed. While the outcome of the 2020 elections is uncertain and we have no idea what the political leanings in Washington will be following the 2024 elections, we do know that the federal deficit has grown since the passage of the TCJA. Whether politicians decide to get serious about addressing the deficit and the debt could impact what future tax rates will be a little over five years from now.

Another argument for using a Roth involves Social Security and Medicare. Withdrawals from traditional IRAs are considered ordinary income for tax purposes and can increase how much of one’s Social Security benefits are taxed. Withdrawals from traditional IRAs also have the potential to increase the amount of Medicare premiums charged. The latter occurs if taxable withdrawals are large enough to bump a Medicare participant into a higher Medicare income bracket. Since Roth IRA withdrawals are not taxable, they do not impact the taxation of Social Security benefits or Medicare premiums.

While this may seem like a positive, the conversion from a traditional IRA to a Roth IRA is a taxable event. In other words, even if your goal is to reduce what you might pay in Medicare premiums, you could inadvertently end up paying more because of the conversion. Similarly, you could end up paying more in federal and state taxes because your income was boosted by the conversion. A commonly suggested strategy is to limit the size of the conversion to an amount that would put you near but not above the thresholds at which you would pay more in taxes and/or Medicare premiums.
When possible, it is generally suggested to pay for the taxes associated with a conversion from an existing taxable account. The IRS also announced the 2020 tax brackets and other inflation adjustments.

There are even more considerations, including the performance of the markets.  The IRS cares only about the dollar amount converted, not the number of shares. So, if a conversion is planned for a certain calendar year, take advantage of a period when the market is down. (Last year, I did a Roth IRA conversion in late December, very close to what ended up being the correction’s bottom.) Roth IRA conversions can no longer be undone (aka recharacterized). Once completed, Roth IRA conversions are final.

Be aware of the five-year rule on withdrawals. You must wait five tax years, starting January 1 of the year you make the conversion, and generally be over the age of 59½ to avoid penalties on withdrawals. Money you anticipate needing sooner should not be converted. A separate five-year rule exists for Roth IRA contributions. It starts when the first contribution to an account is made.
Finally, consider setting up a separate account for Roth IRA conversions during different calendar years. While doing so creates some complexity, it will avoid comingling and potentially help you avoid unintended tax headaches.

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The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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