Are Roth Conversions Right for Everyone?

Transcript of Podcast Episode 252

Hello this is Bill Rainaldi, with another edition of Security Mutual’s SML Planning Minute. In today’s episode, Are Roth Conversions Right for Everyone?

Believe it or not, historically, we are in a period of relatively low income tax rates[i].  Yet, given economic instability, political whims, international conflicts and even wars, social perceptions that the rich don’t pay enough, and a myriad of other reasons, many believe that income tax rates will certainly go up in the future. Hence, we have been bombarded by mass media touting the tax benefits of Roth conversions (i.e., taking a Traditional IRA and converting it into a Roth IRA).

Traditional IRAs were created in 1974 and intended to allow individuals who did not have an employer-sponsored pension plan to save for retirement on a pre-tax basis. Roth IRAs were authorized in 1997 and allow for tax-free growth and tax-free distributions using after-tax contributions. These features have made Roth IRAs extremely popular and attractive for tax and retirement planning purposes, especially because many believe that income tax rates will go up in the future. Also, unlike Traditional IRAs, Roth IRAs do not require you to take certain minimum distributions once you reach the age of 73.

Who wouldn’t rather pay taxes at a time when rates are lower versus higher? Having said all of that, while Roth IRAs have great tax benefits, Roth conversions may not be right for everyone.

Previously, only individuals under certain income tax thresholds were eligible to do a Roth conversion. Today, the income thresholds have been eliminated. While there have been several recent legislative attempts to restrict high-income and high-net-worth individuals from Roth conversions, these proposals have not been enacted into law.

One of the most important consequences of a conversion is that it requires the payment of income taxes at the time of the conversion. And that’s at the heart of the issue for many individuals interested in a conversion. Where do you get the money to pay the taxes? Do you have other after-tax funds to cover the taxes, or do you need to use part of the conversion proceeds for the taxes?

If you take the money from investments like stocks and mutual funds, you will have to pay capital gains taxes on the sale of those assets. If you want to take money out from an existing Traditional IRA, you will have to pay income taxes on that. Also, there may be a 10% premature distribution tax penalty if you’re younger than 59 ½ years old.  You can withdraw your contributions from an existing Roth IRA because those were after-tax monies, but only if you’ve had a Roth account for at least five years. Of course, taking the money from an existing Roth IRA kind of defeats the purpose of doing a Roth conversion of your Traditional IRA accounts. Liquidation of CDs may result in penalties. Having money in other after-tax accounts such as money-market, checking, and savings accounts are generally the best way to pay the income taxes from the conversion.

Obviously, if you don’t have other resources to pay the income tax, or you think you’ll be in a lower income tax bracket in the future, such as in retirement, then a Roth conversion doesn’t make a lot of sense. If you’re fortunate enough to not even need your IRAs for retirement and would like to donate these assets to charity, then paying the income taxes on a Roth conversion also doesn’t make much sense since you would have avoided the income taxes when you donated the money to charity.

If you’re currently receiving Social Security or Medicare benefits, you also probably want to avoid a Roth conversion. The conversion will cause an increase in your taxable income for that year which may impact the taxability or cost of your Social Security and Medicare benefits.

As you can tell, there are quite a few considerations to think about before you do a Roth conversion. There are many more that we didn’t even talk about. Therefore, you should consult with your financial services representative who is familiar with Roth conversions, or your CPA or tax advisor, before you do a Roth conversion.

[i] Tax Policy Center Urban Institute & Brookings Institution. “Historical Highest Marginal Income Tax Rates 1913 to 2023.” Taxpolicycenter.org https://www.taxpolicycenter.org/statistics/historical-highest-marginal-income-tax-rates (accessed 10/2/2023).

[ii] Employee Retirement Income Security Act of 1974

[iii] Taxpayer Relief Act of 1997

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