Converting a traditional IRA or other qualified retirement plan to a Roth IRA can be a powerful wealth-transfer tool under the right circumstances. The key factors to consider include tax implications, future income tax rates, and the intended use of the funds.
How a Roth IRA Conversion Works:
- Roth conversions trigger the 3.8% Medicare surtax for high-income earners, as the conversion amount is included in modified adjusted gross income (MAGI).
- Traditional IRAs (pay taxes later) vs. Roth IRAs (pay taxes now): Traditional IRAs offer tax-deductible contributions but taxable distributions, while Roth IRAs have no upfront tax deduction but provide tax-free growth and distributions.
- The ability to recharacterize conversions was eliminated before 2018, making Roth conversions more permanent.
- Roth IRAs lack required minimum distributions (RMDs), enhancing wealth accumulation and estate planning benefits.
Variables to Consider for a Roth Conversion:
- Taxes: Investors should convert if they expect higher or equivalent tax brackets in retirement, have no short-term withdrawal needs, can pay conversion taxes from outside the IRA, and aim to pass a significant balance to heirs.
- Conversion Costs: A one-time tax bill arises from taxing deductible contributions and growth as ordinary income. For example, a $1 million conversion in the 37% bracket would incur $370,000 in taxes.
- Time to Recoup Costs: Longer time horizons increase the likelihood that tax-free growth will outweigh upfront costs.
- Intended Use: Conversions are beneficial if funds are not needed in the short term, especially for heirs due to tax-free distributions and no RMDs.
- Future Tax Rates: If retirement tax rates are expected to rise, converting now can hedge against higher taxes later. A partial conversion (e.g., keeping some funds in a traditional IRA) can diversify tax exposure.
- Charitable Donations: Traditional IRAs may be preferred for charitable planning, while Roth IRAs are better for tax-free withdrawals.
Top Marginal Tax Rate at Retirement:
- Expectations about future tax brackets heavily influence conversion decisions. If retirement rates are higher, converting now is advantageous.
Measuring Benefits:
- A hypothetical example shows a 65-year-old investor with $1 million in a traditional IRA and $370,000 in a taxable account. Option B (converting using funds from the IRA) and Option C (using taxable account funds) outperform Option A (keeping the traditional IRA) over 30 years, assuming 6% annual returns.
Back Door Roth Strategy:
- High-income earners can use this strategy by contributing non-deductible funds to a traditional IRA and converting to a Roth IRA. However, the pro-rata rule taxes conversions proportionally based on the total IRA balance, impacting efficiency.
Distributions After Account Owner’s Death:
- Spouses inheriting Roth IRAs avoid RMDs, enhancing tax-free growth. Under the SECURE Act, non-spouse beneficiaries must distribute inherited IRAs within 10 years, making Roth IRAs more favorable to reduce beneficiary tax burdens.
Planning for a Conversion:
- Roth conversions offer long-term tax savings and estate planning benefits but require careful consideration of cash availability, time horizons, and future tax rates. William Blair can assist in evaluating conversions as part of a comprehensive wealth management strategy.
