Converting Your Traditional IRA

What is a Conversion?

A conversion is a tax strategy that allows you to convert money from your Traditional IRA into a Roth IRA. The amount converted from the Traditional IRA is generally treated as a taxable distribution and moved into a Roth IRA as a conversion purchase. By doing this, the investor becomes responsible for ordinary income tax on the taxable portion of the converted amount. Going forward, the money in the Roth IRA can grow and be taken out tax free for qualified distributions.

Potential scenarios where a conversion might make sense

You feel the benefit of potential tax-free growth in the future outweighs paying taxes now

Minimizing tax payments can be a key part of your retirement planning strategy, especially the closer you get to drawing on your savings. When the money you worked so hard to save is subject to income tax at withdrawal, the savings that cover your living expenses can shrink by 15 to 20 percent.

Converting your Traditional IRA to a Roth IRA gives you the option of paying taxes up front when you may have a lower tax rate, with the understanding that you won’t have to pay taxes on qualified distributions during your retirement years. As a result, some investors use conversions as a cash flow distribution strategy to keep their tax rates as low as possible during retirement.

Example:
The illustration below is a hypothetical example of when a person filing single and earning 70k/yr converts a $50,000 Traditional IRA to a Roth IRA and is taxed at 15%.

You earn too much money to be eligible to contribute to a Roth IRA

While there are income limitations for being eligible to contribute to a Roth IRA, there are no income limits to contribute to a Traditional IRA.

It’s possible to contribute to a Traditional IRA, then immediately convert the contribution into a Roth IRA and begin taking advantages of the Roth IRA like you originally intended. Before converting, however, speak to a qualified tax advisor so you can consider any income tax associated with the conversion.

Additionally, if the contribution to your Traditional IRA was non-deductible and the conversion was immediate, there may be limited taxes due. And if you have other Traditional IRA assets that haven’t been converted, the tax treatment is different when you only convert a portion of your total IRA. Consult a tax advisor for advice in this situation.

You want to minimize the taxes your heirs will have to pay

In addition to having a will, a critical part of estate planning is making your finances as simple as possible for those that will inherit them. If you find you do not plan on using all your retirement savings, funds converted to a Roth IRA will not be subject to income tax for those that receive them, thereby alleviating some of the tax burden on your beneficiaries.

Outcomes to keep in mind when converting

While working with your tax advisor, you will want to carefully consider the following guidelines.

You're Responsible for Taxes

You will be responsible for the taxable amount of the conversion. Whether you are converting your entire IRA account or a portion of your Traditional IRA assets, the IRS determines the taxable amount on a pro rata basis. This means that investors do not get to specify which dollars to convert (deductible or non-deductible) but rather are taxed proportionate to the amount of after-tax and pre-tax money in the account.

The 5-Year Rule is in Effect

You may incur additional penalties by not converting the full amount of your Traditional IRA if you don’t meet the 5-Year Rule. Withholding some of the account’s money from your conversion may allow you to pre-pay for the income tax on the amount you convert. But you may be better off paying the taxes with a different source to avoid the 10 percent penalty for early withdrawal.¹

Consider Asset Value and Tax Mitigation

It may not be beneficial if the value of your assets decline during the tax year you convert. If you happen to convert and your Roth IRA assets substantially decline after the conversion, you may end up paying ordinary income tax on an amount much greater than your current IRA value. Recharacterizing a conversion is one possible solution to mitigating the tax bill that can result from a conversion but it’s always best to consult a qualified tax advisor before making your decision. However, starting in 2018, it is no longer an option to recharacterize a conversion.