What Is a Roth IRA Conversion? Benefits, Risks, and Key Considerations

What is a Roth IRA Conversion?

A Roth conversion is the process of taking tax-deferred funds held within a traditional IRA or qualified retirement plan (401(k), 403(b), etc.) and moving those funds into a Roth account to grow tax-free.

It is important to note that Inherited IRAs (including inherited SEP IRAs and inherited SIMPLE IRAs, SIMPLE IRAs during the first two years, and Non-Governmental 457(b) plans) cannot be converted.

Why Might Converting Your Traditional IRA to a Roth IRA Be Beneficial for You?

To see if it makes sense for your situation, there are a few different things to consider when converting your traditional retirement account to a Roth IRA. First, if you have reasons to believe that you will either be in a higher tax bracket in retirement or that taxes may increase in the future, you will want to pay the taxes now rather than later. If the majority of your accounts are deferred when it comes to being taxed, you may want to consider having some of those assets in a Roth IRA to create tax diversification so you are not being taxed across all your accounts during the distribution phase. Also, this creates some flexibility for you since Roth IRAs are not subject to Required Minimum Distributions like qualified plans are, therefore giving you more control over your distribution and taxes. As for timing, if you currently find yourself in a situation where you are in a lower tax bracket during any given year than you usually are, this could be a good time to take advantage of this option.

Is There Any Downside to Doing a Roth IRA Conversion?

The main downside of doing a Roth IRA conversion is if your tax bracket ends up being lower in retirement or that taxes go down over time, rather than increase. In this case, it would have made sense to pay taxes on the distributions in the future when taxes would not be as high, but there is no way to predict what the taxes will be in the future. Another potential downside would be where there is an increase in the tax rate of the surviving spouse caused by the loss of the joint brackets. Lastly, converting your traditional retirement account to a Roth IRA does result in a taxable event at the time of the conversion.

What is the process of converting your traditional IRA into a Roth IRA?

To convert your traditional retirement account into a Roth IRA, you will first need to establish a new Roth IRA account. It is recommended to have this done at the same institution that currently holds your traditional retirement account to streamline the process. Inform your current financial advisor of your intention to convert some or all of your traditional assets into a Roth. The financial advisor will provide you with the necessary paperwork to complete and will work with you on determining which holdings are to be converted. It is important to note that the conversion is taxable in the calendar year that it is completed.

Can impending legislation on the horizon prevent me from taking advantage of a Roth IRA conversion?

There is always the possibility that legislative changes could affect Roth IRAs, including conversions. Starting with the Tax Payer’s Relief Act in 1997, which made Roth IRAs possible beginning in 1998, to the reconciliation bill conference agreement in 2010, which eliminated the $100,000 income limit on Roth conversion to the recently proposed “Build Back Better Bill”. This legislation aimed to eliminate the ability to make back door Roth conversions (converting after-tax savings in a 401(k) or a Traditional IRA to a Roth IRA). As of this writing, this bill has not been passed as proposed and we are unsure of the future impact. Either way, this would not impact accounts that have already been converted.

Disclosures