5 Reasons to Reconsider Converting a Traditional IRA or 401(k) to a Roth IRA

An IRA or 401(k) conversion isn’t a one-time decision. The decision needs to be reconsidered during the year as circumstances change. The market volatility of 2022 should cause you to review conversion decisions, no matter what your decision was earlier in the year.

The factors discussed in this article might cause you to do a conversion when you previously decided not to, or you might decide to convert more of the account than you planned. Investment markets were flying high before 2022.

They reversed course and have declined significantly, though they’ve had a modest recovery since late June. When you convert all or part of a traditional retirement account to a Roth IRA, the amount you convert is included in gross income for the year and taxed at your regular income tax rate. You don’t have to change investments into cash to do a conversion.

Investments can be converted in- kind by simply having the shares or other assets transferred from the traditional account to a Roth IRA. With investment markets down, you can convert more of your investments than you could have earlier this year at the same tax cost.

Suppose you owned a mutual fund that had a net asset value of $100 per share on Jan. 1. If the fund is down 20%, each share is worth $80 today. At the start of the year, if you converted 1,000 shares, you would have included $100,000 in gross income.

Now, you can convert 1,250 shares and include only $100,000 in income. You can convert 25% more shares at the same tax cost as at the start of the year. If you still believe these shares are a good long-term investment and their price will bounce back in time, an in-kind conversion today makes more future income tax free. A conversion that wasn’t attractive at the investment prices at the start of the year might be attractive now.

Or if you decided to convert part of an account earlier this year, today’s lower market prices (or even lower prices later this year) might be a good reason to convert more of the account this year. When making this decision, consider both the taxes that will be paid the rest of your life and the taxes that might be paid by beneficiaries who inherit the account.

Heirs will owe taxes on distributions from an inherited traditional IRA or 401(k) just as you would. But if you convert all or part of it to a Roth IRA today, you’re paying future taxes for them. They’ll be inheriting a tax-free Roth IRA instead of a fully taxable account.

That can be a great gift to leave them and a bargain for you when the IRA is converted at a lower market value. In addition, remember that under the SECURE Act, in most cases, beneficiaries have to distribute re- tirement accounts in full by the end of 10 years.

They no longer can use the Stretch IRA, and that increases the tax bill on inherited traditional retirement accounts. Beneficiaries are better off if they inherit a tax-free Roth IRA. (The Roth IRA still must be distributed within 10 years, but the distributions are tax free.) Monitor your investments during the year.

When asset prices dip, many investors wring their hands and wonder if they should sell. A better question is whether that is a good time to increase long-term benefits by converting some assets in traditional retirement accounts to a Roth IRA. Conversions are best done before age 72, when you have to begin taking required minimum distributions (RMDs) each year.

Once you have to take RMDs, the RMD for the year has to be taken before you can convert any amount in the traditional IRA or 401(k).

Having to take that RMD and include it in gross income increases the cost of a conversion. That’s why it’s usually more cost-effective to do a conversion before age 72. But a conversion isn’t out of the question if you’re already 72 or older.

If you’re charitably inclined, consid- er taking your RMD in the form of a qualified charitable distribution (QCD). Instead of taking the RMD personally, the money is transferred to a charity. It is tax free to you but counts toward your RMD. See our April 2022 issue for details about QCDs.

After taking the QCD, you can make a conversion from the rest of the traditional retirement account. Consider likely future taxes, not only today’s tax rates. You know about the potential for future income tax rate increases because of the high federal debt and expanding budget deficit.

Social Security is going to have to be shored up by 2034, and that might be done partially through future income tax increases. But income tax rates aren’t the only factor to consider.

As we age, Congress hits us with the Stealth Taxes. More of our Social Security benefits are included in gross income. After age 65, we’re potentially subject to higher Medicare premiums if we’re considered to be high-income retirees.

The additional Medicare premiums will increase with medical inflation each year. Those are the main Stealth Taxes, but there are others. Distributions from traditional retirement plans are included in your gross income and increase the Stealth Taxes.

But distributions from Roth IRAs aren’t counted when computing the Stealth Taxes. Doing a conversion today can help you avoid or reduce future Stealth Taxes. Remember a conversion doesn’t have to be an all-or-nothing move. You can convert as much or as little of a retirement account as you want. A good strategy is known as serial conversions. For several years, convert just enough each year to keep from pushing your taxable income into the next higher tax bracket.

Another good time to convert part of a retirement account or increase the amount you convert is when your taxable income is going to be lower this year than initially thought, because of either lower income or higher deductions. The death of a spouse is another reason to reconsider converting all or part of a retirement account.

The year a spouse passes away is the last year an income tax return can be filed as a married couple filing jointly. The next year, the surviving spouse must file as a single taxpayer. The change can cause a substantial increase in taxes, even when income is lower.

The year the one spouse passes away might be the lowest tax rate faced by the surviving spouse for the rest of his or her life. Before starting a conversion, be sure you have enough funds out- side the IRA to pay the taxes on the conversion.

You can take money out of the IRA to pay the taxes, but you’ll owe taxes on that money. Essentially, you’re paying taxes on taxes, and the conversion is much less likely to pay off. You’re better off using money in a taxable account to pay the conversion taxes.