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Is a Roth IRA Conversion Right for You This Year?

The COVID-19 pandemic has caused significant instability in the global markets and the U.S. economy. In these uncertain times, AAFCPAs reminds clients to consider measures to protect your retirement nest egg over the long term. One strategy our clients are considering is converting a traditional IRA to a Roth IRA.

Traditional vs. Roth

First, let us review the key differences between traditional and Roth IRAs:

Traditional IRAs. Contributions to a traditional IRA may be wholly or partially tax-deductible. But deductions are phased out if these two conditions are met:

  1. Your modified adjusted gross income (MAGI) exceeds a specified level, and
  2. You (or your spouse if you are married) are an active participant in an employer-sponsored retirement plan.

Therefore, depending on your situation, some or all of your traditional IRA may not reflect deductible contributions.

Traditional IRA distributions that are attributable to deductible contributions or growth in the account are taxable at ordinary income rates.

Roth IRAs. Contributions to a Roth are never tax-deductible, regardless of your MAGI (though your ability to contribute in a given year may be phased out if your MAGI exceeds certain limits).

Qualified distributions from a Roth IRA that has been in existence for at least five years are 100% tax-free. For this purpose, qualified distributions include withdrawals:

  • Made after age 59½,
  • Made on account of death or disability, or
  • Used to pay qualified first-time homebuyer expenses (up to a lifetime limit of $10,000).

Nonqualified Roth IRA distributions are taxed at ordinary income rates under special “ordering rules.” When you take a distribution, contributions are treated as coming out first, so this part is exempt from tax because the contributions were not deductible. This treatment is followed by conversion and rollover amounts and, finally, earnings. These ordering rules reduce any potential tax liability during the first five years of the account’s existence.

In other words, when you convert assets in a traditional IRA to a Roth, you are usually doing it for the lure of tax-free payouts in the future. But a conversion does come with other unique considerations.

Factors to consider

Under prior law, you had until October 15 of the same year to reverse (or “recharacterize”) an ill-fated conversion. For example, a reversal might have been advised if you converted the account and then asset values subsequently declined. However, under the Tax Cuts and Jobs Act, for 2018 and beyond, you can no longer recharacterize a Roth IRA back into a traditional IRA.

So, it is important to think through the details before you convert to a Roth IRA. Some of the questions to ask when deciding whether (and when) to make a conversion include:

  • How much tax will you owe? When you convert to a Roth IRA, you must pay tax on the funds transferred, just like a traditional IRA distribution. You might not want to convert if your account balance is high and you expect asset values to drop. Conversely, a declining value might encourage a conversion.
  • Do you have money to pay the conversion tax bill? If you do not have enough cash on hand to cover the taxes owed on the conversion, you may have to arrange to pay the tax out of the funds being converted. This will erode your nest egg. The more money you convert and the higher your tax bracket, the bigger the tax implications.
  • What is your retirement horizon? Your stage of life can affect your decision. Typically, you would not convert a traditional IRA to a Roth IRA if you expect to soon retire and start drawing down on the account right away. Usually, the goal is to allow the funds to grow and compound over time without any tax erosion.
  • How do you expect your tax rate to change in retirement? If you anticipate being in a lower tax bracket when you retire than you are in now, you may not want to convert. That is, it might be easier to absorb tax on future distributions than it is to pay a conversion tax this year. On the other hand, if you expect to be in a higher tax bracket in retirement than you are in now, a conversion now often makes sense, absent any other facts & circumstances. To complicate matters, Congress could change tax rates in the future.
  • Will you have other sources of retirement income, besides your IRAs? If most of your retirement funds are invested in assets that would trigger taxes on distribution, such as growth stocks or a 401(k) plan, a Roth conversion may provide some flexibility later in life. It can help meet your lifestyle or estate planning objectives without triggering tax on every withdrawal. Because you cannot predict how the tax laws will change over time, it is a good idea to build some tax diversification into your accounts.

AAFCPAs also encourages clients to consider required minimum distributions (RMDs). While RMDs have been waived for 2020 due to the COVID-19 pandemic, normally with a traditional IRA, you must begin taking RMDs by April 1 of the year after the year you turn age 72. (This age was raised from age 70½ by the SECURE Act, effective for taxpayers who did not turn age 70½ before January 1, 2020 – that is, who were born after June 30, 1949.) For each subsequent tax year, an RMD must be made by December 31 of that year.

However, there are no mandatory lifetime distributions with a Roth IRA. This can help preserve wealth for your heirs.

A common misconception

Converting a traditional IRA to a Roth IRA is not an all-or-nothing deal. You can convert as much or as little of the money from your traditional IRA account as you like. So, you might decide to gradually convert your account to spread out the tax hit over several years.

A gradual conversion strategy can allow you to pay the conversion tax from money currently at your disposal instead of tapping into your retirement funds. As a result, your nest egg will not be diluted by the amount you have to subtract to pay the tax.

Furthermore, if you convert a traditional IRA in stages, you may pay less tax overall because more of the transferred amount will be taxed at lower rates under the federal graduated income tax rate system.

What’s right for you?

We encourage clients to contact your AAFCPAs Tax Advisor before converting a traditional IRA to a Roth IRA. We can discuss the pros and cons, along with providing other retirement planning recommendations.

If you have any questions please contact: Dave McManus, CPA, CGMA, at 771.512.4014, dmcmanus@nullaafcpa.comAndrew Hammond, CFP®, at 774.512.4143, ahammond@nullwealth.aafcpa.com;  or your AAFCPAs Wealth Management Wealth Advisor.

This commentary on this website reflects the personal opinions, viewpoints and analyses of the AAFCPAs Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by AAFCPAs Wealth Management, LLC or performance returns of any AAFCPAs Wealth Management, LLC client. The views reflected in our commentaries are subject to change at any time without notice. Nothing on this page constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. AAFCPAs Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

About the Authors

David McManus CPA
Dave leads AAFCPAs’ Commercial Tax Practice providing highly coveted tax, entity structure, and business advisory solutions.  He has over three decades of proven experience advising manufacturers & distributors, real estate developers, high tech, bio tech, and renewable energy businesses.
Andrew Hammond
Andrew is a Partner and Wealth Advisor at AAFCPAs’ Wealth Management, a Registered Investment Advisory (RIA) Firm whose mission is to provide valuable peace of mind to those who share the awesome responsibility to manage wealth. He provides comprehensive and carefully designed financial plans for individuals & families, nonprofits & foundations, and retirement plan sponsors. Andrew joined our team of advisors after 17 years in financial services at Fidelity Investments. He joined AAFCPAs because of the firm’s deep tax expertise, individualized approach, and commitment to honesty, ethics, and developing meaningful relationships with each client.