Should I Convert My Traditional IRA to a Roth?

Deciding when the best time is to pay taxes on your retirement assets is often tricky and depends on multiple factors—your current income and financial situation, future financial expectations, and even personal preference or personality type. Traditional IRAs allow you to make pre-tax contributions that you pay taxes on when you withdraw the money; whereas Roth IRAs allow you to generate tax-free income in retirement by paying taxes now and making post-tax contributions. 

So which method is best for you, and should you consider converting your tax-deferred income to a tax-free account? Traditional IRAs allow you to add pre-tax dollars (and therefore accrue gains on a larger base amount, if you haven’t met the yearly maximum contribution), but there are several reasons you might want to consider converting your taxable retirement assets to a Roth IRA.

Minimize Your Beneficiary’s Tax Burden

The SECURE Act was one of the biggest retirement legislations to pass in a decade, and it made changes to the retirement landscape that make Roth conversions more attractive. One reason is that the act has effectively killed the so-called “Stretch IRA.” Under the previous law, when a beneficiary inherited an IRA, they could keep the assets invested inside the IRA and take an annual withdrawal based on a Required Minimum Distribution (RMD) amount for as many years as the account contained funds. This allowed the beneficiary to "stretch" the IRA over their lifetime—which meant they could disperse the taxes owed and ultimately withdraw more cash from the inherited funds.

With inherited IRAs, withdrawals are taxed as income in the year the withdrawal occurs. That means if the RMD amount was $100,000, your beneficiary would have to withdraw that amount from their inherited IRA each year, making their taxable income for the year increase by $100,000—which could cause the rest of their income to also be taxed at a higher rate.

Under the new law, the maximum number of years you can stretch an inherited IRA is ten years (in most cases). This makes a tax-deferred account like a traditional IRA even less desirable for estate planning, since it means you could potentially leave your heirs a heftier tax burden they have to manage in a shorter amount of time.

As such, a Roth IRA might be a more tax-efficient asset to pass on to your heirs. Under the new law, your beneficiaries would still have to withdraw the funds within ten years, but the money would be considered tax-free in most cases.

Avoid the RMD

Speaking of your Required Minimum Distribution… Roth IRAs don’t have an RMD amount when you’re in retirement. That means that if your funds are in a Roth rather than a traditional IRA, your funds could grow tax-free for life without ever being reduced by mandatory withdrawals—ultimately allowing you to leave more tax-free assets to heirs. And again, because your Roth distributions are tax-free, you avoid increasing your own taxable income in retirement.

Altering Your Taxable Income

The other thing to consider is that many retirement benefits are based on your income level. Medicare supplement premiums and taxes on your Social Security benefits both use your income level to determine the benefit you receive and the taxes you pay on those benefits. For married couples filing jointly who claim more than $44,000 in income, 85% of their Social Security benefit is taxed as income. On top of that, 50% of their Social Security benefit counts toward that income calculation.1

So, if a couple receives a total of $50,000 in Social Security benefits, $25,000 counts toward their income calculation. That means if they receive just another $19,000 in income from any another source, they’re now above the $44,000 threshold and will be taxed on 85% of their Social Security benefits.

Any withdrawals from tax-deferred accounts (including RMDs) count as taxable income and could ultimately put you in a higher income tax bracket. Conversely, withdrawals from Roth IRAs are generally tax free and therefore don’t count toward that income calculation.

Take Advantage of Low Tax Rates

When you transfer funds from a traditional IRA to a Roth IRA, the amount you convert counts as taxable income the year the conversion takes place. In other words, if you convert $50,000 of un-taxed income this year from your traditional IRA to a Roth IRA, that $50,000 that would count as taxable income on your next tax return. So it’s important to evaluate if it makes sense for you to pay these taxes now, wait to convert, or keep your funds in a traditional IRA.  

You can usually have your financial institution withhold the taxes for you if you choose (rather than pay out of pocket the year you convert). But consider this—do you think it’s likely that taxes will increase in the future, or decrease? Most people assume taxes are only going to rise as time goes on, which is why it might make more sense to pay the taxes now, as opposed to years later when taxes will (likely) be substantially higher.

In addition to the ordinary escalation of tax rates, changes to the individual tax rates from the Tax Cuts and Jobs Act will likely end after the year 2025.2 This means most people will see a lower-than-usual tax bill for the next few years—making now the perfect opportunity to take advantage of a Roth conversion.

Take the Next Step

If you haven’t considered how to diversify your taxes in retirement, now is the time to evaluate whether your financial plan is primed to give you the best return. If you’d like to discuss converting some of your tax-deferred assets into a tax-free retirement account, we’d love to help. Give us a call or click the button below to schedule a consultation.