Know When an IRA Conversion Is Most Likely to Pay Off
Near the end of the year, many people consider whether to convert a traditional IRA to a Roth IRA. IRA owners should look through- out the year for good opportunities to convert all or part of an IRA, but interest seems to increase at year’s end. Many variables determine whether a conversion will pay off or not, and I always recommend using software that considers the variables and lets you can change them as needed. Yet, there are events and situations that are likely to increase the benefits of a conversion.
IRA owners should be alert for these and then do an in-depth analysis of whether a conversion now makes sense. In a conversion, assets are rolled over from a traditional IRA to a Roth IRA. It is taxed as a distribution, so the rolled over amount is included in the IRA own- er’s gross income for the year and taxed as ordinary income. Income and gains compound tax free in the Roth IRA.
After the owner has had any Roth IRA opened for at least five years, all distributions are tax free. Dis- tributions to beneficiaries who inherit a Roth IRA also are tax free. Required minimum distributions (RMDs) after reaching age 72 don’t apply to the original owner of a Roth IRA. (Beneficiaries who inherit Roth IRAs face the same RMD rules as beneficiaries of traditional IRAs.) The optimum time to consider a conversion is after the working years are over. The time is especially good when the IRA owner also hasn’t reached age 72 or begun taking Social Security benefits.
The individual is likely to be in a lower tax bracket than during the working years, doesn’t have to take an RMD before doing the conversion, and there’s no risk the conversion will increase in- come taxes on Social Security benefits. Another good time to consider a conversion is after the IRA’s value has declined due to market changes. Because of the lower value, the same number of shares of stocks or funds can be convert- ed at a lower tax cost than at the start of the year. When you believe the values will rebound over time, the shares are be- ing converted to future tax-free income at a discount.
Conversions during the working years still might be a good idea, though it is likely the IRA owner won’t be in a lower tax bracket during retirement. Many people have modest IRAs and other assets. They will need to take at least the RMDs to fund their retirements. They’re not prime candidates for conver- sions. The best candidates for conversions are those who won’t need RMDs to pay for retirement expenses.
For them, RMDs will be nuisances that increase their income taxes, trigger higher taxes on Social Security benefits, increase the Medicare premium surtax and cause other problems. People in this situation should consid- er converting a portion of their tradi- tional IRAs to reduce their future RMDs. While it’s preferable to convert before age 72, conversions after 72 still can be profitable. The higher a person’s net worth and IRA balance, the more likely it is that a conversion will pay off. For them and others, a conversion is an excellent estate planning tool. The IRA owner essentially pays the income taxes for the heirs, yet it doesn’t count as a taxable gift. Shifting the traditional IRA to a Roth IRA avoids dumping tax problems on the beneficiaries.
Conversions usually are the most effective when they are done over a period of years. You generally want to avoid converting so much in one year that it pushes you into the next higher tax bracket, triggers taxes on your Social Security benefits or increases your Medi- care premium surtax in two years. It is important to consider more than current and future income tax rates. You want to know if the conversion might trigger any Stealth Taxes (such as higher Medicare premiums and taxes on Social Security benefits) and factor those taxes into the cost of the conversion. How the Roth IRA will be invested influences the potential benefit of a conversion.
The higher the investment returns of the Roth IRA, the more you’ll benefit from the conversion. It might not make sense to convert when the Roth IRA will be invested very conservatively. You want the Roth IRA to hold your assets with the highest potential returns, so you’ll be maximizing the future taxes that are avoided.
