In this post, I'll cover my top three reasons to convert to a Roth IRA.
Prior to the Tax Cuts and Jobs Act, recharacterization offered you the ability to undo the Roth conversion, making it like it never happened, The tax law eliminated that option. This has caused many to reconsider whether converting to a Roth IRA makes sense.
However, if you make too much money to contribute to a Roth but want the benefits a Roth IRA offers, the only way to get a Roth is to convert traditional IRAs (or 401(k) plans).
If you've followed my writing at all, you know that I'm a big believer in investors having control of their money. Roth IRAs give you that control. So, the three reasons to consider converting are about control.
#1 You control when and how much to convert
The industry standard advice surrounding IRAs is to take the tax deduction up front and let the money grow in a tax-deferred account as long as possible. The idea is to build up the largest possible retirement account value when you need it.
But is that the best option?
Remember, at age 70 1/2, the IRS requires you to begin withdrawing your traditional IRA money. Called required minimum distributions (RMDs) this must be done over your life expectancy. In general, they determine that under their Uniform Life Tabe.
That strategy may be more costly in the long run. If you've never paid taxes on any of the money you contributed to a traditional IRA, you will likely pay a larger tax bill during retirement. Why? Your account value will be much higher, resulting in a higher overall tax bill. Additionally, that may increase taxes on Social Security and throw you into a higher tax bracket during retirement (when you have less money to pay). That, in turn, could mean your money doesn't last as long as it should. To adjust, you may have to reduce the amount of income you originally wanted. Not good outcomes!
#2 You control how much and when you pay taxes
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As a result, you control how much tax you pay each year.
I have clients whose IRAs are their largest asset. The larger their account grows, the higher their tax bill during retirement. We are working on converting some of those IRAs each year between now and the time they reach age 70 1/2. When they reach age 70 1/2, they will have less money in taxable IRA accounts. For that reason, Required minimum distributions (RMDs) will be substantially lower.
Remember, when you take money out of a traditional IRA, you pay tax on that money in the year in which it's withdrawn. Whether the money is taken out in the traditional manner or via the Roth IRA conversion, you owe taxes for the year you take out the money. If you're under age 59 1/2 when you withdraw, you pay an additional 10% penalty tax. The exception to that is for a Roth IRA conversion. The 10% penalty is waived.
Conversion Strategy Example
One Roth conversion strategy to consider is called the “fill-up-the-bracket” strategy. It's also called the Roth conversion ladder. Here's how it works.
Investors convert just enough of their traditional IRAs to keep them in their current marginal tax rate. Let's say their 2018 tax bracket is the new 24% bracket. If filing as an individual, the band is $82,500 to $157,500. If married filing a joint return, the band is between $165,000 and $315,000.
In the fill-up-the-bracket strategy, an investor would convert just enough money each year to prevent their adjustable gross income from going above the top income level for that bracket (either $157,500 or $315,000). Granted, they're going to pay more taxes in the years you convert. Some people don't like that prospect.
Here's the question – would you rather pay more tax while you're making a higher income or in retirement when, presumably, your income is lower? An argument can be made that it doesn't matter. Your income is lower, so your tax bill is lower too. Maybe. But again, no one has a crystal ball on what tax rates will be.
If you make too much income to contribute to a Roth IRA, another way to get into a Roth is via the backdoor Roth IRA.
The backdoor Roth IRA is simple on the surface. The first step is to make a non-deductible contribution to an IRA. As we discussed earlier, income limits do not apply for non-deductible IRAs. Stick to the contribution limits, and you're good to go.
For easier accounting, I recommend keeping your non-deductible IRA separate from IRAs in which you made pre-tax contributions.
Once the IRA is in place, the second step is to convert the traditional IRA to a Roth IRA. Here is where the potential pitfalls come into place. You might think that since you've already paid taxes on the non-deductible IRA contributions, you won't pay taxes when you convert.
However, if you have traditional IRAs funded with pre-tax dollars, Roth IRAs funded by converting traditional IRAs, and other non-deductible IRAs, any withdrawals will be subject to the pro-rata rule. That means you will pay taxes on the converted money.
The backdoor Roth is a good option. But like most things, it's important to know the rules. Penalties for breaking them are costly.
Taxes now or taxes later?
I've heard numerous convincing arguments from advisors, bloggers, and others on both sides of the tax argument. One argument says to take the tax deduction now while your income is higher. The deduction means more to you now than when your income is lower. That's true enough.
The other part of the argument says you will likely be in a lower tax bracket in retirement so the IRA distributions won't affect you that much. There's a major hole in that argument. How do you know what tax rates will be in retirement? If anyone could predict that, they'd never have to work another day in their life!
To me, it isn't an either or answer. It makes sense to own both traditional and Roth IRAs. Planning for tax rates is nothing but a guessing game. Having diversity in your IRA accounts brings more options. As you near retirement, you'll know more about your income, your investments, your expenses, and other financial needs. If you've planned properly along the way, you'll know in plenty of time to take advantage of the best options.
If your income and tax rates are lower, draw on the traditional IRAs first. That reduces the RMDs at age 70 1/2. If you expect your income to remain the same and tax rates are higher, consider the Roth conversion ladder along the way. Tax-free income in retirement just makes more sense to me.
#3 You control when and how much income you take
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That gives you complete control of when and how much income you take.
If you have a pension (in metro DC where I am, government workers still have pensions) you likely don't want or need income from your IRAs. If you have saved enough and have sufficient funds in your taxable investment accounts, you may not want to take money out of your IRA accounts. You pay ordinary income tax rates on money taken out of traditional IRAs. Money withdrawn from taxable investment accounts held over one year gets lower, more favorable capital gains tax treatment (either 15% or 20% under current law).
Having your investments diversified across different types of investment accounts (taxable accounts, traditional IRAs, Roth IRAs) offers the opportunity to develop a withdrawal strategy to maximize your income while minimizing the taxes you pay on that income.
Converting to Roth IRAs increases the amount of money you can withdraw tax-free at retirement. The flexibility and control you get from Roth IRAs are much greater than from other types of retirement accounts. So, if you don't want to take money out of your Roth, don't. It will continue to grow tax-free in the account.
All of my top three reasons to convert to Roth IRAs have to do with one thing – control. In summary, here are the three ways you gain control.
- Deciding when and how much to convert each year. Remember, if you own multiple IRAs, you need not convert them all. In addition, you don't have to convert the full amount of any individual IRA. Partial conversions are another way you gain control.
- Controlling when and how much tax you pay. The flexibility in converting all or a part of individual IRAs allows you to only take income and pay taxes in the amounts you decide.
- You control when and how much income you take. If you're age 70 1/2 or older, that means you are not required to take RMDs. Take income or not. It's up to you.
Now it's your turn. Have you converted traditional IRAs to Roth IRAs? Have you thought about it but never done it? If so, was this post helpful? Please let me know in the comments below.