Roth Conversion Guide – April 14, 2020

Many of you may hear someone extolling the benefits of a Roth Conversion. While there are situations where a Roth Conversion makes sense there is also broad misunderstanding of what it is and what to look for to see if it might be right for you.

What is a Roth Conversion? 

A Roth conversion is a penalty-free taxable transfer from a traditional IRA to a Roth IRA. The dollar amount you convert – all or part of your IRA – will be taxable income to you in the year the conversion occurs. The amount converted to the Roth IRA will grow tax-free and can be withdrawn tax-free (if you have had a Roth open for at least 5 years and are over 59.5 years old). Other types of accounts that may qualify for a Roth conversion include qualified plans, SEP & SIMPLE IRAs, 403(b) Plans, and Section 457 Plans.

Roth conversions can be a great tool when used properly. Yet there are many factors to consider before proceeding with a full or partial Roth conversion. This post is meant to be a general guide to help evaluate if a Roth conversion is appropriate for you.

Why consider a Roth conversion? 

To diversify your tax exposure – If you convert from a traditional IRA or other tax deferred savings vehicle to a Roth, you are shifting a portion of your assets into a different tax-favored status. If most of your assets are currently tax-deferred, converting a portion of these assets to a Roth can help to manage taxes in your retirement years.

If you think taxes will rise in the future – Many taxpayers believe that income tax rates are only going to go up over time. If that is the case, paying the tax now and taking withdrawals tax-free later would be a benefit.

To maximize wealth transfer to beneficiaries – Because Roth IRAs are not subject to Required Minimum Distributions (RMDs) in the account owner’s lifetime, they can be an effective tool for legacy planning. Beneficiaries of Roth IRA’s are subject to different withdrawal rules depending on their relationship to the original account owner. However, if your ultimate beneficiary is a charity, a Roth conversion would not be beneficial.

Income expectations: if your income is expected to increase in the future or if you are currently earning lower than normal income – This scenario ties into higher future tax rates but is very relevant for what we see happening in 2020. If there is a year when your income is expected to be lower than usual, it might be a good time to consider conversion opportunities. This also applies if you expect that your income will substantially increase in later working years. Again, if you are in a lower tax bracket now than what you expect to be in future years, it may benefit you to convert.

Your income was too high to convert before the TIPRA changes – TIPRA stands for The Tax Increase Prevention and Reconciliation Act. Before 2010, some higher-earning individuals were not allowed to convert due to a MAGI limit of $100,000, along with marital status restrictions. Those income limits and restrictions have since been lifted and it might be worth taking another look at a Roth conversion if this changes your situation.

Is a Roth conversion right for me? 

This decision tree details specific questions you should ask yourself when considering a Roth conversion. Although it doesn’t provide a definitive answer, it can help you understand the underlying factors that make converting to a Roth IRA beneficial.

Taking money out of your emergency fund to pay taxes associated with a Roth conversion is not recommended. If you have the free cash flow to max out retirement accounts (Roth or otherwise) and are not currently doing so, we recommend that those contributions take priority. If you are maxing out relevant retirement contributions, have free cash flow, and answered yes to the questions above, then a discussion surrounding converting some or all of your eligible pre-tax dollars to a Roth IRA might be worthwhile.

This post is meant to be used as a tool to help you understand Roth conversions on a deeper level. However, we understand everyone’s situation is different, and questions may still linger. Your Albion team is available to answer your questions or concerns as they relate to your situation. Thank you all for staying engaged and allowing us to assist and guide you through these tough times.

Stay safe and healthy,

Patrick, Jen & the Albion Team

About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.