Whether an investor should convert a traditional ira to a roth ira depends on the IRA owner’s specific circumstances and assumptions. With the income limit on converting from a Traditional IRA to a Roth IRA eliminated every investor should consider whether it is to their advantage to convert.
Since the Roth IRA provides tax free compounding and tax free income in retirement is a powerful investment vehicle. The downside of conversion is paying the income taxes on the amount withdrawn from the Traditional IRA. The tax on the money withdrawn from the Traditional IRA should always be paid from money outside the IRA. If IRA money is used to pay the tax you may owe a 10% penalty on IRA withdrawals before age 59 ½.
Who Should Convert a Traditional IRA to a Roth?
The longer you have to wait before making withdrawals the longer the money has to grow tax-free. Those in their 20’s and 30’s would almost certainly benefit from converting. The number of years of compounding makes it almost impossible for them to not come out ahead. Most people in their 40’s will benefit too.
Unemployed and Underemployed
Those who have lost jobs or had their income cut significantly, but have the savings to pay the tax, can convert and pay a much lower tax rate than if their income were high. It’s possible to not even have to pay any tax, making conversion a no-brainer.
Retirees Who Don’t Need the Money
Unlike a Traditional IRA, a Roth IRA is not subject to the required minimum distributions (RMDs) during retirement. Regardless of how old the owners are, they do not have to withdraw from the Roth IRA if they don’t need the money.
Investors Who Want to Pass Wealth to Future Generations
Investors can reduce their estate tax bill by converting to a Roth IRA. If your potential estate is near the federal estate-tax exemption, converting to a Roth IRA could reduce or even eliminate your estate’s tax bill. The money required to pay the taxes on your Roth conversion would no longer be part of your estate. The amount remaining in the IRA continues to compound tax-free. Although the heirs of the estate would be subject to mandatory distributions on inherited Roth IRAs, they would benefit because there will be no income tax on the withdrawals. The heirs can stretch out the withdrawals over their life expectancy; not the owners’ life expectancy; another big benefit.
Who Should NOT Convert an IRA to a Roth IRA?
Lower Tax Bracket After Retirement
If an IRA owner expects to be in a lower tax bracket after retirement it might make sense to pay the tax when withdrawn from the Traditional IRA. Also the tax deduction for Traditional IRA contributions is worth more in peak earning years.
Moving to Another State in Retirement
If an investor plans on moving in retirement, take into account the state tax of the current state versus the new state. Converting at a later time may make sense if moving from a high tax rate state to a low tax rate state.
Plan on Gifting or Donating IRA
Investors who plan on gifting or donating from an IRA may not want to convert to a Roth. The tax bill on a Traditional IRA is waived when the money goes to charity. When gifting an IRA, consider the tax rate of the beneficiary; they may be in a lower tax rate and therefore save taxes by not converting.
Before making such an important decision you should always check with your financial advisor to be sure a conversion is right for you. Because of the benefits of the Roth everyone should consider whether it is to their benefit to convert an IRA to a Roth IRA.
Related Reading: Planning Investment Accounts for Retirement