You have probably read about the ability to convert traditional IRAs into Roth IRAs. Because these are two quite different financial instruments, whether this would be a good move depends on your particular situation, goals, and the timing involved.
The feasibility of contributing to a Roth, after you convert to one, hinges on your current and projected income. For healthcare professionals at lower income levels, these conversions can be more feasible and beneficial than for physicians. Yet, if they use the right strategy, physicians can also benefit substantially.
The main attraction of converting to a Roth is that, because these accounts are funded with post-tax dollars (income that’s already been taxed), distributions carry no tax on withdrawals of earnings—but only if certain conditions are met (including a five-year waiting period). By contrast, every pre-tax dime withdrawn from a traditional IRA—both contributions and gains on investments—is taxed at your ordinary income tax rate.
IRS rules require holders of traditional IRAs to begin gradually withdrawing money in the form of required minimum distributions (RMDs) starting at age 72 to wind down and ultimately deplete these tax-deferred accounts. And after RMDs begin, no further contributions are allowed. On the other hand, RMDs don’t apply to Roth IRAs, and you can contribute to these accounts as long as you have earned income—i.e., wages, salaries, fees or commissions received for work you do.
Because of a relatively recent change in tax rules, Roth conversions are now irreversible, as are their tax consequences. So, it’s more important now than ever to understand the impact of a Roth conversion.
Though conversions can provide distinct benefits, they can also trigger unintended consequences that can be highly disadvantageous. Understanding these impacts is critical to making an informed decision about whether to convert a traditional IRA to a Roth. Financial planners and popular articles on the subject tend to extol the benefits of Roth IRAs without exploring downsides of Roth conversions. Also underemphasized are the mechanics of conversion strategies, based on individuals’ particular circumstances.
Here are some points to think about when considering whether to take this step:
In this situation, a viable strategy might be to convert the year after retiring, while delaying the start of retirement income streams, such as Social Security (which must be claimed by the age of 70) and any pensions until the year after completing conversions. Thus, even high-earning physicians could not only qualify for a Roth, but could also achieve a much lower tax bracket in the first year of a conversion process, and keep their bracket low while converting subsequent tranches. For high earners, this period between retiring and the beginning of retirement income streams is sometimes referred to as the golden zone for Roth conversions.
If your estate’s value is close to this limit, completing a Roth conversion might be advisable, because paying the taxes would reduce the size of your estate, possibly helping to keep it below the exemption amount and thus sparing your heirs the burden of estate tax.
Moreover, inheriting a Roth instead of a traditional IRA holds significant other tax advantages for heirs, especially surviving spouses. By becoming the account holder through what’s known as a spousal transfer, spouses become subject to the rules for new accounts: gains cannot be withdrawn tax-free for five years, and account holders must be at least 59½ to avoid a tax penalty on these withdrawals. But after that, the account is treated as their own originally. There are no RMDs, and they can keep the account for life and leave it to their heirs. These heirs have 10 years to distribute all the account’s assets—to liquidate them and withdraw all the money, tax free.
This is also required of non-spouse heirs who inherit your Roth. Beneficiaries who receive traditional IRAs also have 10 years to distribute assets, but they must pay taxes on these distributions. For those inheriting a large IRA, the 10-year limit can mean a decade of much higher tax brackets.
To give your both spouse and non-spouse heirs these advantages, you will probably have to wait until you retire to convert, assuming that it is feasible based on your earned income.
If the heir is your grown child and you leave him or her a traditional IRA instead of a Roth, the taxes on distributions might be a lot lower than yours depending on the child’s tax bracket.
By fully understanding the impacts of a Roth IRA conversion on your current and anticipated financial picture, you can make an informed decision about whether to take this step and, if so, how and when.
David Robinson, a CERTIFIED FINANCIAL PLANNER™ professional, is a director and senior wealth advisor with Mariner Wealth Advisors in the firm’s Phoenix office. He provides wealth planning services and creates custom financial plans to help clients grow and protect wealth, manage taxes and identify insurance solutions. He also prepares clients for retirement and manages estate plans. Prior to joining Mariner Wealth Advisors, he was CEO of Robinson, Tigue and Sponcil, an SEC-registered advisory firm in Phoenix.