What to consider before a Roth conversion
I receive a great deal of mail from readers asking about the pros and cons of Roth conversions from traditional IRA accounts. This year, many individuals are considering Roth conversions because of a drop in the value of their IRA portfolio. That could lower the income tax liability of a conversion.
Others will find it a better time to convert because their taxable income in 2020 took a hit from unemployment or other economic factors.
Many people had funds taken out of their retirement accounts early in 2020 to meet anticipated required minimum distributions (RMD). But the coronavirus relief bill, or CARES Act, signed into law in March, lifted the requirement for RMDs in 2020. Accordingly, if you have withdrawn assets this year for an RMD, the IRS has indicated that you have the option to redeposit these funds back into your retirement accounts as long as you do so by Aug. 31. You also may roll over any distributions into a Roth IRA. However, if you decide to do a Roth conversion, the amount you convert will be taxable at ordinary income tax rates.
The primary advantage of a conversion to a Roth is that, as long as you maintain the account for five years, all distributions, including income and gains, are income-tax free whenever you make withdrawals. In addition, your beneficiaries will never have to pay income taxes on any withdrawals.
However, all assets converted, based on pretax contributions, are taxable in the year of conversion. Any conversions you do are irreversible. If you convert a large amount, you may find that your marginal tax rate is higher for that year.
Anyone with a retirement account that’s eligible to be rolled over can do a Roth conversion. According to IRA specialist Ed Slott (www.irahelp.com), that includes individuals with SEP IRAs and SIMPLE IRAs (after the first two years). Plan participants in 401(k)s, 403(b)s and government 457 plans also can do Roth conversions as long as they are eligible to take a distribution from the plan and the funds are eligible for rollover to an IRA. Some plans will allow in-service distributions so that funds can be converted now instead of after you stop working for your current employer.
There is no 10% early distribution penalty at the time of a Roth conversion. However, that penalty can be assessed if any of the converted amounts are distributed to the Roth owner within five years of the conversion, when the owner is under the age of 59 1⁄2 at the time of the distribution.
Before you do a conversion, you should consider these issues:
■ When will the funds be needed? Generally a 10-15 year time horizon is recommended.
■ What do you anticipate future income tax rates to be, compared to your current tax rate? In general, conversions make more sense when you anticipate that the marginal tax rate at the time of your withdrawal will be more than your current marginal tax rate.
■ Do you have the available funds to pay the income tax associated with the conversion?
■ Because of the current year tax liability associated with the amount of converted assets, IRA owners should consider partial conversions to avoid large tax liabilities in one year that also could increase their marginal tax bracket.