FINRA's BrokerCheck

Now’s the time to consider a Roth IRA conversion

The Roth IRA is an attractive retirement savings tool, offering tax-free earnings, tax-free withdrawals, and no minimum distribution requirements. And now may be an ideal time to convert your traditional IRA into a Roth. The Tax Cuts and Jobs Act (TCJA) temporarily reduces individual income tax rates, enhancing the benefits of Roth IRAs and lowering the cost of conversion.

No time like the present 

Generally, you should consider converting to a Roth IRA if you expect your tax rate to be higher in the future. By temporarily reducing individual income tax rates from 2018 through 2025, the TJCA creates a window of opportunity to convert to a Roth IRA while your tax rate is lower. You’ll owe taxes (but not penalties) on the amounts you convert, to the extent they’re attributable to deductible contributions and earnings on those contributions. But, because qualified distributions from a Roth IRA are tax-free, converting now allows you to avoid taxable distributions later, when rates are higher.

Here’s an example: Fred and Wilma, a married couple filing jointly, have taxable income of approximately $200,000 per year and a traditional IRA with a $560,000 balance. Both are 62 years old, and will reach age 70½ in 2026. Right now, they’re in the 24 percent tax bracket for federal tax purposes, but in 2026 their marginal rate will increase to 28 percent. If they keep their traditional IRA, they’ll have to begin taking required minimum distributions (RMDs) in 2026, whether they need them or not, subject to tax at 28 percent.

Instead, to take advantage of their current 24 percent tax rate, Fred and Wilma convert their traditional IRA into a Roth IRA in increments of $70,000 per year from 2018 to 2025. Converting the IRA gradually spreads out the tax liability over several years and ensures that the conversion doesn’t push them into a higher tax bracket (the 32 percent rate applies to taxable income over $315,000). In addition to lowering their tax bill, converting allows them to avoid RMDs (there are no distribution requirements for Roth IRAs). Because their assets outside the IRA are sufficient  to meet their needs, they can allow their IRA assets to continue growing tax-free indefinitely. And if they hold the Roth IRA for life, they can leave it to their children or other beneficiaries income-tax-free. An inherited traditional IRA would saddle their loved ones with a hefty tax bill.

Traditional vs. Roth

For many people, Roth IRAs offer significant benefits, but they’re not right for everyone. Both traditional and Roth IRAs are tax-advantaged accounts. The difference between them is with the timing of income taxes. Contributions to traditional IRAs are deductible — that is, they’re made with pre-tax dollars. Taxes on both contributions and earnings are deferred until you withdraw the funds during retirement. There’s a 10 percent penalty on early withdrawals (before age 59½), unless one of several limited exceptions applies.

Contributions to Roth IRAs, on the other hand, are nondeductible, meaning they’re made with after-tax dollars. But you can withdraw your contributions any time — without taxes or penalties — and “qualified distributions” of earnings are tax-free. Generally, a qualified distribution is one made after age 59½ and more than five years after your first Roth IRA contribution. (Note: special rules apply to Roth IRA conversions; see below)

So, which type of IRA is right for you? Purely in terms of tax savings, the answer hinges on whether you’re better off paying tax now (a Roth IRA) or later (a traditional IRA). If you expect to be in a lower tax bracket after you reach age 59½, a traditional IRA offers a lower tax bill. But if you expect your tax rate to rise after you reach age 59½, a Roth IRA will minimize your tax liability. Of course, you should also consider the time value of money. Depending on your circumstances, a traditional IRA’s tax-deferral benefits may be preferable even if you expect your tax rate to be higher in the future.

Converting to a Roth IRA

High-income taxpayers are ineligible to contribute directly to a Roth IRA. In 2018, for example, contributions are phased out once your modified adjusted gross income (AGI) reaches $135,000 ($199,000 for joint filers). Modified AGI is your AGI, with certain tax breaks — including deductions for traditional IRA contributions and student loan interest — added back in.

Even if your income level prohibits direct contributions, you can convert traditional IRA assets into a Roth IRA. 

Handle with Care

If you’re interested in a Roth IRA conversion, talk to your advisor to determine whether it makes sense for you. Although the potential benefits are significant, careful planning is critical because conversions are now irrevocable. The TCJA eliminated a provision that made it possible to “undo” a Roth conversion (up until the extended tax return due date for the year of conversion) if changing circumstances or market conditions erase its benefits.

Securities offered through Rehmann Financial Network, LLC, member FINRA/SIPC. Investment advisory services offered through Rehmann Financial, a Registered Investment Advisor. 1500 W. Big Beaver, Troy, MI 48084 | 248.952.5000.

Meet The Rehmann Team

Start typing a name ...
Searching for "{{nameQuery}}"...
Start typing a experience ...
Searching for "{{experienceQuery}}"...
Start typing a location ...
Searching for "{{locationQuery}}"...
Or view a list of team members