If you have an individual retirement account as part of your retirement savings, advisers say it might be a good time to consider converting it to a Roth IRA. That’s because your tax bill associated with such transactions tends to be lower in a down market.
Before committing to a conversion, however, investors should consider several other issues, including the upfront costs.
A Roth IRA is a retirement account funded with after-tax dollars. Both earnings on the account and withdrawals after age 59½ are tax-free. Assets in a traditional IRA, which are typically funded with pretax dollars and taxed when the funds are withdrawn, can be converted to a Roth to take advantage of these benefits.
Timing is important
“Typically we will wait until November or December to do conversions because you have a better sense of what the [client’s] annual income figure is going to be, but we have opted to move up the timeline in some cases,” says Pete Hunt, director of client services at Exencial Wealth Advisors in Charlotte, N.C. “You can convert to a Roth in parts—doing some now and more later, and it could make sense when you look at the total portfolio.”
There are other factors besides market volatility that can affect when it makes sense to convert to a Roth IRA, and preplanning can allow you to avoid some common pitfalls.
For starters, Roths have a five-year rule, meaning that once assets are converted they can’t be used for five years without paying a steep penalty. So, if you anticipate needing the assets in a Roth sooner than five years, you might want to convert only a portion of your IRA assets, advisers say.
Converting to a Roth also can help investors avoid taking required minimum distributions, or RMDs. Current law requires investors with traditional IRAs to start withdrawing money—and paying taxes on the withdrawals—once they reach age 72 whether they need the money or not. If you convert to a Roth, you don’t have to take those distributions. And once you start withdrawing from the Roth based on your own actual needs, the withdrawals are tax-free.
Jeff Mattonelli, a financial adviser at Van Leeuwen & Co. in Trenton, N.J., says if investors convert early enough in retirement, there’s an ideal window where they can usually afford to manage through the five-year rule and then also avoid RMDs. “Congress is also considering a change to RMD rule—moving it to age 75—which if passed, would extend the window and give more investors the opportunity to convert,” he says.
A mind-set shift on taxes
Keep in mind that converting to a Roth will require a hefty upfront tax bill based on the amount of assets being converted. That payment can be taken out of the total amount being converted or it can be paid using other cash, but it’s important to pay the total amount at the time of conversion. If you wait until you file your taxes, you could be subject to additional late-payment penalties. On paper, this can look like a big tax bill, but you need to compare it to what you would owe overall if you paid taxes incrementally each time you took a withdrawal from the account.
For example, the tax cuts afforded by the 2017 Tax Cuts and Jobs Act are set to expire by 2026. This means some investors could find themselves in a higher tax bracket when the cuts expire and be forced to pay higher taxes on RMDs over the length of their retirement. If that’s you, it might be worth paying the tax now at a lower rate, advisers say. “It’s kind of a mind-set shift,” Mr. Hunt says. “We’ve been looking at tax cuts since Reagan in the ’80s, so retirees are thinking ‘defer defer defer.’ But it’s hard to see that being the case over the next 30 years.”
Note that converting can give you more taxable income in the year or years in which you do conversions. And depending on your current age, that increase in adjusted gross income could affect your Medicare premiums and/or put you in a higher tax bracket. A financial adviser and tax planner can help you estimate future costs to determine whether these increases are more or less than the total potential tax liability over the length of retirement.
“It’s difficult to game out the lifetime benefits and costs of Social Security, Medicare, RMDs and taxes on your own,” especially since the rules that govern these accounts are likely to evolve over time, says Kevin O’Regan,
senior wealth adviser at Kayne Anderson Rudnick. “Additionally, if you intend to leave the assets to a beneficiary, the heirs could have to pay taxes and other fees on those accounts for several years. Creating a plan for that and having someone manage the process can help avoid penalties in the future.”Ms. McCann is a writer in New York. She can be reached at reports@wsj.com.
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Is It a Good Time to Convert a Traditional IRA to a Roth IRA? - The Wall Street Journal
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