Converting a traditional IRA to a Roth IRA takes some fortitude and faith in the future numbers because this change can accelerate your tax bill. The current market and tax rate cuts from President Trump’s plan, however, are creating an environment ripe for conversions and making the move much more palatable. Together, these two factors are essentially creating new groups of taxpayers for whom a conversion makes good sense.
IRA Basics Revisited
Contributing to a traditional IRA gets you a tax deduction now, at the time of your contribution and allows your money to grow tax free. You’ll also need to begin withdrawing your annual required minimum distributions (RMDs) once you hit age 70½, with whatever you take out taxed as ordinary income. Roth IRAs operate differently, as your contribution is made with after tax income but in return your investments grow tax-free and you pay no tax when you finally withdraw the money.
Roth Conversion Mechanics
Under a conversion you choose to pay tax at the time of the conversion on the money in the traditional IRA and transform the account into a Roth, making all future gains and withdrawals free from taxation. The ability to convert was limited for many people, however, because back when Congress created Roth IRAs, there were income limits above which the conversion was not allowed. In 2010, the government removed the income restrictions on conversions and now anyone can make a conversion.
Running the Numbers
Understanding if making a conversion is worthwhile requires calculations that depend on assumptions of tax rates in the future and investment performance. Generally, if you believe your investments will be worth more and the tax rates will be higher when you withdraw the money, then a conversion makes sense.
Benefiting from the arbitrage on tax rates between now and the future often requires spacing out the conversion over multiple years. The idea is to convert just enough out of the traditional IRA to raise your income until it’s just below the next higher tax bracket. The recent tax cuts to individual rates make the conversion option a lot clearer as they both cut rates and expanded tax brackets.
Finding the Sweet Spot
Under the previous tax law, the sweet spot for many people was after retirement but while they were still under 70 and not yet taking RMDs. The widening of the 24 percent bracket means that the sweet spot for converting will extend to a greater number of taxpayers, both younger and older.
No Second Chances
The new law cut out the ability to “re-characterize” conversions. Re-characterization allowed taxpayers to unwind a Roth conversion any time before Oct. 15 the year after you convert. The idea is that if you convert $250,000 at the beginning of the year and then the market drops dramatically (like in 2008 when the S&P 500 fell almost 40 percent) you could unwind the conversion and do it again later when the balance is lower (and therefore your tax bill from the conversion as well). There are no more do-overs under the current tax law.
One strategy to mitigate this risk is to convert specific investments first if you are looking at a multi-year conversion strategy, focusing on those that are performing the worst. The idea is that they are more likely to go up in the future, like when you re-balance a portfolio to harvest your best performers and buy more of those that are down. Another strategy is to take a cost-averaging strategy to conversion.
In the end, the real payoff comes not from market timing, but from making the conversion and allowing the money to grow tax-free for decades, taking advantage of the power of compounding and then reaping the rewards tax free. If you have assets in a traditional IRA, now may be a good time to talk with a financial planner to see if a Roth conversion is the right move for you.