Should you do a Roth IRA conversion?

You may have heard of a Roth IRA conversion and are wondering (a) what is it and (b) should you do it?

What is a Roth IRA conversion?

As the name implies, this is when you “convert” a pre-tax IRA into a Roth IRA.^* The IRS allows anyone to do this for any amount of your pre-tax IRA balance at any time. You will owe income tax on the amount converted, just as you would if you took a distribution from a pre-tax IRA. There is no income limitation to be eligible to do a conversion, nor is there any limit to how much you can convert.

This can be a sensible tax planning move, depending on your present circumstances and how you see your financial future unfolding. It can also be a big mistake at the wrong time.

Should you do it?

A Roth IRA conversion may be prudent, if you answer YES to both of the following questions:

1. Is your taxable income — and thus your marginal tax bracket — in this current year lower than what you expect it to be during your retirement?
2. Do you have savings available outside of your IRA to pay the taxes that you’d owe from doing a conversion? Don’t use funds in your IRA to pay the taxes you’ll owe as you’ll be shrinking the amount of tax-sheltered savings you have.

There are some secondary considerations that make this decision more complicated to sort through:

1. Where do you live now versus in your future retirement?

States tax IRA distributions differently, including not at all. For example, if you live in a high tax state now (say NY or CA) but expect to retire in a low tax state (say FL or NV), you may not want to do a conversion as you’ll pay state tax on the converted amount that you could avoid if you distributed the money later while residing in FL or NV.

2. Do you want to reduce this year’s adjusted gross income (AGI)?

Doing a conversion will increase your AGI and if you want to qualify for certain income-based programs such as need-based college financial aid for your kids, income-dependent student loan repayment plans, Obamacare subsidies, federal pandemic relief checks, or (ironically) eligibility to contribute to a Roth IRA, you’ll want to be careful to not push your AGI above whatever income threshold is relevant to your situation.

3. Do you want to reduce your future AGI?

Doing a conversion now will decrease your future AGI in retirement because of reduced required minimum distributions from your remaining (now smaller) pre-tax IRA. This can be useful, for example, if you’re a high income retiree and are trying to minimize future Medicare surcharges. It may make sense to do a conversion and increase your AGI now so that it will be lower in future years and you can avoid these surcharges.

4. Can you predict the future?

Probably not and you may not know where you’ll retire, what your future income will be, or if federal tax policy and income tax rates will change. This makes it a trickier decision but possibly a good reason to diversify the tax status of your assets.

When is it not a good idea?

Generally, if you currently have a high income and you reside in a state with a high income tax rate, now is probably not the moment to do a Roth IRA conversion. And, if you don’t have the spare cash to pay the income tax you’ll generate from doing this, then skip it.

Also, if all of your net worth is tied up in pre-tax retirement accounts, it’s probably not going to be sensible to do a conversion.

When may it be a good idea?

Here are two examples of when it may make sense to do a conversion:

1. If you’ve recently retired, your taxable income is currently low because you’re living off your savings, and you expect your income to increase in a few years when you collect Social Security and receive IRA distributions, now may be a good time to do a Roth IRA conversion.
2. Similarly, if you’re currently in graduate school with little or no income and you have a previous pre-tax retirement account, this may also be a good time to do a conversion, assuming you have the cash to pay the tax that will result.

Roth IRA conversions can be a helpful tax planning tool. But, keep in mind it’s not an “all or nothing” proposition. You can convert as little or as much as you chose and then take a fresh look at your financial situation each year.

* Note that a conversion is different from, and unrelated to, a rollover which typically refers to rolling over an old 401K or 403B into an existing or new IRA. You may think you are “converting” a 401K into an IRA (and in plain english, you are) but in IRA-speak, it’s a rollover. (Yes, the terms are confusing.)