Is a Roth conversion right for my portfolio?

Tyler Kert
Tamarack Wealth Management

As we approach the end of the year, I often start getting questions about Roth conversions. Roth conversions can be a great option for the right person, at the right time, with the right income, in the right tax bracket… you get the picture. So rather than telling you “It depends” and moving on, this article will seek to outline a few critical qualifications you should take into consideration before moving forward with a Roth conversion. No one knows the future and therefore, no one is guaranteed to make the right choice when it comes to Roth conversions. But, if you are willing to consider the following points, your odds of making the right choice will increase significantly.

First, for those that don’t know, a Roth conversion is simply the process of taking cash, securities, or other investments held in a traditional IRA and moving them into a Roth IRA. Because a traditional IRA contains “pre-tax” money and a Roth contains “post-tax”, this process triggers ordinary income tax on the entire amount converted. In exchange for paying the ordinary income tax, you achieve tax-free growth going forward. Before you voluntarily decide to pay more to the IRS, you’ll want to consider the following items.

What tax bracket are you in?

The heart of a Roth conversion is a tax trade-off: you pay taxes now in exchange for avoiding them later. So, the first thing to consider is whether your tax rate today is lower or higher than what you expect in retirement. If you’re temporarily in a lower tax bracket either because you had a down year for income, or you recently retired but haven’t started taking Social Security, converting some of your traditional IRA can make a lot of sense. You’re essentially locking in a lower tax rate now and giving yourself tax-free income down the road.

On the other hand, if you’re currently earning at your peak and expect to have lower income in retirement, paying taxes today could cost more than waiting. 

More often than not, people don’t easily fit into the previous two categories. Instead, they fall somewhere in between. In that case, a popular option is to “fill up” your current bracket without spilling into the next one. These kinds of bracket-filling Roth conversions are the essence of strategic tax planning. It’s not an all or nothing decision.

Can you afford the tax bill?

A Roth conversion creates taxable income for the year, which means you’ll owe taxes on whatever you convert. If you don’t have cash outside your IRA to pay that tax bill, you shouldn’t do a conversion. It’s never a good idea to generate a tax bill that you can’t pay.

Ideally, you’ll have saved enough in a taxable account or bank account to pay the tax from outside the IRA. That way, the full converted amount stays invested in the Roth and grows tax-free.

Have you considered Social Security and Medicare?

This one often catches people by surprise. A Roth conversion increases your adjusted gross income (AGI) for the year, which can affect other parts of your financial life. Higher income could mean higher Medicare premiums (thanks to IRMAA surcharges) or a greater portion of your Social Security benefits becoming taxable.

If you’re retired and already on Medicare, a big conversion could push your premiums up in a subsequent year. It may still be worth doing the conversion, but it’s something to factor into your timing and the size of your conversion.

What do you want to leave the kids?

If you’re thinking about legacy planning, a Roth can be one of the best gifts you leave behind. Unlike a traditional IRA, your heirs won’t owe income tax when they take distributions even though they’ll still have to empty the account within 10 years.

This makes Roth accounts incredibly efficient for passing on wealth. Plus, since Roth IRAs don’t require required minimum distributions (RMDs) during your lifetime, you can let the account continue growing as long as you want, potentially creating a lasting tax-free legacy for your family. RMDs also stand for “Really Mean Demands” from the IRS so getting out of these mean demands or greatly reducing them is a large selling point for many clients.

Summing it up

I’m tired of using the phrase “If you would have…” with people I meet with. You can’t go back in time to complete a Roth conversion. By the time you file your tax return, it’s too late. But if you do your research and talk to a tax or financial advisor about whether a conversion is right for you, you’ll be able to make a much more informed decision. Remember this: the IRS loves people that don’t plan.

This material is for informational purposes only and does not constitute financial, investment, or tax advice. Please consult your tax advisor or financial planner to discuss your specific circumstances before making any decisions. Securities offered through Cetera Wealth Services LLC, Member FINRA/SIPC. Advisory services offered through Cetera Investment Advisers LLC, a registered investment adviser. Cetera is under separate ownership from any other named entity.

Tyler Kert, a licensed financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA.