Illustration by Cathryn Cunningham/ Albuquerque Journal
Roth IRAs offer many benefits over traditional IRAs. I have written previous articles, encouraging readers to build their Roth IRAs through contributions or conversions. Recently I received several emails from readers who are convinced of the long-term benefits of converting a traditional IRA to a Roth IRA, but are hesitant due to the taxes that a Roth conversion triggers. They requested more information in order to make a wise decision.
One reader told me he has done extensive research on Roth conversions. He concluded that the decision to convert comes down to paying the tax now rather than later. He is spot-on. The key is to determine if paying the taxes sooner rather than later is a wise decision. This is a personal decision, and you must analyze the pros and cons for you and your family.
Death and Taxes
Benjamin Franklin said “Nothing is certain except death and taxes.” This is definitely true for traditional IRAs.
Traditional IRAs are tax-deferred while you are working, and the amount you contribute to a traditional IRA (or traditional 401(k) or 403(b)) typically provides you with a tax break in the year you contribute. The taxman comes later. Withdrawals from traditional IRAs are allowed without penalty after age 59½, and Required Minimum Distributions (RMDs) begin at age 73. All withdrawals from traditional IRAs are fully taxable. In 2033, the starting age for RMDs increases to 75. The RMD for the first year is approximately 3.7% of the Dec. 31 value of the traditional IRA the prior year. Each year the percentage increases slightly as you get older.
There is no easy way to avoid paying the taxes on a traditional IRA. If the IRA is not depleted before you die, your beneficiaries will pay the taxes. (The only exception is to leave your traditional IRA to a charity).
Unlike with traditional IRAs, withdrawals from Roth IRAs are tax-free, and RMDs are not required. This allows the money to stay in the Roth IRA for many years, growing and compounding tax-free. Contributing to a Roth IRA (or Roth 401(k) or 403(b)) does not provide a tax benefit in the year of the contribution. In short, traditional IRAs are tax-deferred, and Roth IRAs are tax-free.
Moving assets from a tax-deferred status to a tax-free status seems like a wise move. What’s the problem? Well, the problem is taxes. The government wants investors to pay the taxes on the traditional IRA that was previously tax-deferred. With a traditional IRA, the IRS will recoup the taxes on your withdrawals and from your beneficiaries. If you want to move a traditional IRA to a Roth IRA, the IRS wants their taxes in the same year as the conversion. If it were not for this provision, everyone would be doing Roth conversions.
There are far too many details to cover every issue in this article, but we will cover the key factors.
Why Convert?
The question is: “Should you pay taxes now (on the conversion) in order to get the money moved from a traditional IRA to a Roth IRA?” If you answer “yes” to any of the following issues, perhaps a conversion is wise.
- You expect tax rates to go up in the future. The tax cuts that took effect on Jan. 1, 2018 as part of the “Tax Cuts and Jobs Act” are scheduled to sunset on Dec. 31, 2025. If Congress doesn’t extend the lower rates, the higher tax brackets from 2017 will return in January 2026.
- You want to leave money to your children or grandchildren. If this is your wish, leaving a Roth IRA is much better than a traditional IRA. When a non-spouse inherits a traditional IRA the full amount is taxable, and it must be withdrawn within 10 years following the inheritance.
As an example, let’s assume you have a $500,000 traditional IRA when you die, and you leave it to your daughter. She may choose to withdraw it equally over 10 years, which would add $50,000 to her taxable income each year. If she inherited a Roth IRA from you, the withdrawals would still need to come out within 10 years, but they would be tax-free.
- The amount of your RMD from your traditional IRA will be large enough to trigger tax problems. Most traditional IRAs are not excessively large, and the withdrawals do not create tax problems. However, some people nearing retirement have accumulated traditional IRAs with values of $1,000,000, or more. These are the ones that some financial advisors have labeled a “tax bomb.”
In 2007 the U.S. government started charging higher premiums for Medicare Parts B and D for high-income earners. These can be as high as $7,000 a year, or $14,000 for a married couple. These payments are called IRMAA, or “Income Related Monthly Adjustment Amount.” Having large RMDs can push you into a higher bracket for IRMAA each year.
There are no RMDs required for Roth IRAs, and withdrawals are all tax-free. Therefore, triggering IRMAA is not an issue.
One strategy that prevents an RMD (from a large traditional IRA) from causing tax problems is to donate your RMD to a charity via a “qualified charitable distribution.” This strategy eliminates the taxable income that an RMD would typically trigger, but you have given away the RMD, and you do not receive a charitable tax deduction.
- RMDs can also trigger a larger portion of your Social Security benefits to be taxed.
- You do not anticipate needing the money from the RMD for living expenses. If you have a pension, Social Security benefits, and other income, the RMD may not be needed, and it may just add to your taxable income each year. In this case, converting to a Roth IRA (where RMDs are not required) may be wise.
Why Not Convert?
If you answer “yes” to any of the following factors, a Roth conversion may NOT be wise.
- Your traditional IRA is not unusually large, and the RMDs will help fund your cash flow needs each year. This is the way traditional IRAs were intended to be used.
- You expect future tax rates to be the same or lower than they are now.
- You do not have money available outside of your traditional IRA to pay the taxes in the year of the conversion.
- You plan to spend the money in less than five years. A Roth conversion has a five-year holding requirement for each conversion.
- You (or your spouse) plan to spend your traditional IRA before you die, and you do not plan to leave it to children or grandchildren.
- You do not want to pay taxes any sooner than necessary, and you do not see the long-term benefits of a Roth IRA.
- You plan to leave your traditional IRA to a charity when you die.
More Details
If possible, Roth conversions work best in years where you have lower income than usual. This may occur after you retire, but before you begin Medicare and start receiving Social Security benefits. However, this “window of opportunity” is not always available.
If you decide to do a conversion after starting Medicare or Social Security, be aware that the conversion (which triggers taxes that year) may also lead to higher IRMAA payments or higher taxes on your Social Security income. If you are over 70 and are taking RMDs, you must take your RMD first before doing a Roth conversion. However, you can do a Roth conversion at any age.
If you do not have a “window of opportunity” with a low-income year, Roth conversions can be done at any time. You can convert any amount of a traditional IRA to a Roth IRA. If we assume you have a $500,000 traditional IRA, perhaps you want to look at converting $25,000, $50,000, or $100,000 in 2023. Your tax preparer can “model” different amounts of conversions to estimate what the taxes will be on the conversion. This can also be modeled using tax software such as TurboTax®.
Roth conversions allow you to customize your strategy. As an example, let’s assume you have a $200,000 traditional IRA, you do not believe you will need it all for living expenses in your senior years, and you want to leave some of it to a child or grandchild. You could decide to convert $20,000 per year for five years, and you would then have a $100,000 Roth IRA that will be tax-free going forward. You would leave the remaining $100,000 in your traditional IRA for you to spend as needed.
If you have access to a Roth 401(k) or Roth 403(b) through your employer, I recommend funding the Roth portion rather than the traditional portion. This is a great way to build your Roth over time. You can also make a contribution to a Roth IRA by April 18, 2023, for the tax year 2022 if you qualify. The rules for Roth contributions are very different than Roth conversions. (See IRS.gov for details).
The Bottom Line
Roth IRAs have many benefits over traditional IRAs. However, doing a Roth conversion — and experiencing the long-term, tax-free benefits of a Roth IRA — comes down to paying the taxes sooner rather than later. Unfortunately, death and taxes are certain.
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Donna Skeels Cygan, CFP®, MBA, is the author of The Joy of Financial Security. She owned a fee-only financial planning firm for over 20 years and she is now writing a new book, Sage Choices After 50: A Guide for Women Who Want More Freedom and Financial Security, that will be published in 2023.