In the financial industry, when individuals want to transfer all or part of a Traditional IRA, SEP IRA, or SIMPLE IRA into a Roth IRA, we tend to call it a “Roth conversion.” Why the name? Well, a “Roth conversion” has a specific set of uses that help enable people to manage their taxes more effectively.
Since Betterment is not a tax advisor, we can’t provide actual tax advice on how a “Roth conversion” would affect your specific tax situation, but there are generally three main benefits people point to when talking about whether a “Roth conversion” would be a useful move for their finances.
3 Potential Benefits of a Roth Conversion
Taking Advantage of What a Roth IRA Does
At a basic level, when you execute a Roth conversion, you’re moving from the benefits of having a Traditional IRA to the benefits of having a Roth IRA—which means that you’re opting to pay taxes now rather than during retirement. Generally, with a Roth IRA, as long as you have had the account for more than five years and are over 59½ (or are disabled), you won’t have to pay any taxes when you withdraw money at retirement.
If you expect that your tax rate will be the same or higher than your current rate when you plan to withdraw money, paying taxes on that money now could mean a better after-tax return overall.
But why convert from Traditional? Well, there are a few key limitations to Traditional IRAs that might drive IRA holders to consider a Roth conversion. Here’s one.
Avoiding Required Minimum Distributions in Retirement
The IRS’ rules for a Traditional IRA require that once a person reaches a certain age, they must begin taking required minimum distributions from their IRA every year. This means that a Traditional IRA holder must eventually begin withdrawing some money from their IRA each year and pay taxes on any amount that has not already been taxed.
A Roth IRA does not require minimum distributions, so for some future retirees this could be a big advantage.
Moving to a Roth IRA When Your Income Exceeds Roth IRA Limits
Because Roth IRAs have income limits, not all investors can contribute to them directly. However, if you have a Traditional IRA, you are allowed to contribute to it first and then convert those contributions into a Roth IRA afterwards, even if your income exceeds the IRS’ set limits.
Financial advisors often refer to this move as a backdoor Roth IRA, because it enables you to move your money into a Roth IRA by contributing first to a Traditional IRA. However, this switch can be complicated.
The Disadvantages of a Roth Conversion
Of course, alongside the above benefits, there are also disadvantages of a Roth conversion that investors should consider. For instance, typically, a Roth conversion has some kind of tax impact.
Some disadvantages of a Roth conversion include the following:
- You may have to pay income taxes now on conversion amounts that were previously deducted from your income. If your Roth IRA is with Betterment, we will not withhold these funds for you, so it requires a little bit of extra work on your end to make sure you settle up with the IRS.
- The converted amount will be added to your adjusted gross income for the year, and could potentially increase your tax bracket overall.
- Taxpayers with incomes or an adjustable gross income (AGI) over $200,000 who file individually or $250,000 for married couples filing jointly could also be subject to a 3.8% net investment income tax on the converted amount, so it might make sense to spread any conversions out across several tax years or delay converting until the “extra” tax can be avoided. Exceptions apply. Read more about the tax.
- Per the Tax Cuts and Jobs Act passed in 2017, Roth conversions are not able to be reversed. Therefore, any completed conversion is deemed final. For context, under old rules, you were able to reverse, or recharacterize, a Roth conversion up until the October 15th filing deadline. Due to the permanency of this transaction, you should always refer to your tax advisor before making a decision.
Listen Up Michiganders
If you live in Michigan, there are special requirements for completing your conversion.