Should you convert your IRA to a Roth before year end?

While you can convert your tax-deferred IRA to a Roth IRA at any time during the year, for some reason December seems to be when tax-planning issues grab our attention.

December may be good timing, as there are benefits to doing a conversion over a number of tax years instead of all at once.

First, let's go back to basics. Traditional IRAs are taxdeferred; Roth IRAs are taxfree.

High earners ($153,000 or more of MAGI — modified adjusted gross income — if you are single; $228,000 or more if married filing jointly) are not eligible to contribute to them. However, there are no limits to who can convert all or part of an existing traditional IRA to a Roth IRA. It used to be conversions were also restricted by income thresholds, but that all changed more than a decade ago, in 2010. Now, anyone can convert, but should they?

Taxes come into play. When you withdraw funds from a Roth, the IRS doesn't get involved. Withdrawals are not taxed; nor are they subject to required minimum distribution rules during the owner's lifetime, unlike traditional IRAs. RMDs are withdrawals that you are required to take from a traditional IRA after you reach age 73. Those RMDs trigger income taxes. So, for example, if your RMD withdrawal is $10,000, your IRA custodian will send you a Form 1099-R, reporting taxable income of $10,000.

The act of converting a traditional IRA to a Roth requires a withdrawal that triggers an income tax. If you convert $10,000, you will receive a Form 1099-R reporting $10,000 of taxable income due to the conversion. However, from that point on, your $10,000 Roth will never be subject to RMDs or to income taxes during your lifetime. Your heirs will be subject to Roth RMDs, but those withdrawals will not generate taxable income.

And here is the big distinction between Roths and traditional IRAs: No income tax liability is triggered when you take money out of your Roth. The only hitch is that you have to wait five years after setting up the Roth before starting withdrawals, and you have to be age 59 1/2 or older at that time. The technical term for a tax-free Roth withdrawal is a “qualified withdrawal.”

How do you know if a conversion is right for you? You won't, until you explore your rationale for doing a conversion.

If you are thinking of converting now in order to have tax-free withdrawals, you need to consider your tax cost today compared to how much your Roth can grow by the time you need to start withdrawals at some point in the future. The longer that time horizon is, the better. Try out the Vanguard Roth Conversion Calculator at tinyurl.com/mr3cuzs4 to run a few “What if ?” scenarios.

If, instead, you are thinking of the Roth for your beneficiaries, that's another story. That Roth will continue to grow during your lifetime and beyond for another 10 years, when the Roth must be fully withdrawn (income tax-free) by your heirs.

In any case, again, you'll need to run some numbers, ideally with the tax bill for the conversion being paid out of another pocket — and not the traditional IRA.

If you decide to go ahead, think about doing a partial conversion before year's end to capture the tax obligation in 2023. You can time the next conversion for the 2024 tax year, and so on.

Finally, don't leave out your CPA, as there are a number of potential missteps that you will need to avoid. For example, you need to know how to apply the “pro rata” rule if you have more than one IRA. Don't go it alone, especially if you have a large potential tax liability to pay due to the conversion. You'll also want to check how the conversion might affect your estate plan.

Seasoned Investment Counsel and award-winning columnist and author, Julie Jason, JD, LLM, promotes financial literacy and investor protection. Read her latest book, “The Discerning Investor: Personal Portfolio Management in Retirement for Lawyers (and Their Clients),” published by the American Bar Association. Write to Julie at readers@juliejason.com. While all questions cannot be answered, each email is read and reviewed and can lead to discussion in a future column.