Roth IRA Conversions - When, Why And How To Convert A Traditional IRA To A Roth IRA

by: Alpha Gen Capital

Summary

Pros and cons of both traditional and Roth IRAs.

Strategies for when and how to convert to a Roth IRA.

Should you convert?

Is converting your traditional IRA to a Roth IRA the right move for you? There are many factors that need to be considered to answer this question. Remember, a traditional IRA is a taxed deferred vehicle where you pay ordinary income tax on the withdrawals made. A Roth IRA uses after tax money and grows it tax free. Both are effective retirement funding tools to save and reduce exposure to income taxes.

By converting, you will effectively be taking pre-tax (tax deferred) money and pay the taxes on them at your current marginal rate, thereby making them after tax dollars. They then can be placed in a Roth IRA and grow tax free for the remainder of the account owner's life.

The complication is, this may not always be the right move. Let's first examine each account and the differences of each. The IRS website has a handy table that compares the two:

Features Traditional IRA Roth IRA
Who can contribute? You can contribute if you (or your spouse if filing jointly) have taxable compensation but not after you are age 70½ or older. You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below certain amounts (see 2016 and 2017limits).
Are my contributions deductible? You can deduct your contributions if you qualify. Your contributions aren’t deductible.
How much can I contribute?

The most you can contribute to all of your traditional and Roth IRAs is the smaller of:

  • $5,500 (for 2015 - 2017), or $6,500 if you’re age 50 or older by the end of the year; or
  • your taxable compensation for the year.
What is the deadline to make contributions? Your tax return filing deadline (not including extensions). For example, you can make 2016 IRA contributions until April 18, 2017.
When can I withdraw money? You can withdraw money anytime.
Do I have to take required minimum distributions? You must start taking distributions by April 1 following the year in which you turn age 70½ and by December 31 of later years. Not required if you are the original owner.
Are my withdrawals and distributions taxable? Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Also, if you are under age 59 ½, you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception. None if it’s a qualified distribution (or a withdrawal that is a qualified distribution). Otherwise, part of the distribution or withdrawal may be taxable. If you are under age 59 ½, you may also have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.

(Source: IRS.gov)

Limitations

There are many nuances and restrictions that each must abide by. Some of those differences are:

  • Traditional IRAs do not have income limitations; Roths have a phase out for certain income. However, traditional IRA's tax deduction may be phased out if you make over a certain AGI.
  • Roth IRAs require that the first contribution be made at least five years prior to the first withdrawal otherwise you will have to pay a penalty. You only have to meet that requirement once and afterwards you will have only paid taxes on what went into the account, not the sum you eventually take out.

Withdrawals

  • Both Traditional and Roth IRAs allow owners to begin taking penalty-free, “qualified” distributions at age 59½.
  • For Traditional IRAs, if you're under 59½, you can withdraw up to $10,000 from your account without the normal 10% early-withdrawal penalty to pay for qualified first-time home-buyer expenses and for qualified higher education expenses. Hardships such as disability and certain levels of unreimbursed medical expenses may also be exempt from the penalty, However, you’ll still pay taxes on the distribution.
  • Traditional IRAs must make required minimum withdrawals at 70 1/2 years old. Roth does not. However, if you inherit a Roth IRA, you will have to make those RMDs (Required Minimum Distributions). But you will not have to pay any federal taxes on those withdrawals.
  • Roth contributions, but not the earnings can be withdrawn at anytime (even before 59 1/2). Similar to Traditional IRAs, you can withdraw $10,000 for qualified expenses

According to the IRS, the one-IRA rollover per year rule doesn't apply to Roth conversions. The IRS specifically says, “Rollovers from traditional to Roth IRAs (“conversions”) are not limited.” And since there are no income limits for making a conversion, you could conceivably do as much as you want, when you want.

When To Convert

Paying as little tax as possible is every taxpayer's goal. By converting to a Roth, you may save significantly on your future tax burden. Ideally, you want to convert the bulk of your traditional IRA into a Roth in the year where you anticipate lower income (and therefore a lower tax bracket). Since your income is lower, the tax you pay on the conversion will be at a lower marginal rate.

Roths are the best choice for younger workers, since those in their 20s and 30s for the most part expect their careers to progress and therefore earn more in their 40s and 50s. Since they are earning less early on, they will pay less tax liability. So as young workers roll over their 401(k)s as they move from job to job, they can convert these funds to Roth IRAs at their current tax rate.

Another time to consider converting is if the government announced tax rate increases for the following year, a conversion to a Roth in the current year would save income tax. And if you convert, you will not owe any more tax on the converted funds - both with principal and growth of those funds - for the rest of your life.

Remember, if you find yourself out of a job for a short period, this may be the opportune moment to convert. Most people wouldn't have IRA conversion as their top priority if they find themselves unemployed but it may be the best time to do it since you will conceivably be earning less in this calendar year than if you worked the entire twelve months. Some people may find it disconcerting to increase their tax base in a year when they may be unemployed but this is exactly when it may be the most opportune.

Conversion can also be an estate planning tool. If the estate is large enough, you can decrease your estate taxes by converting to a Roth. Depending on your tax bracket and situation, the conversion amount may be less than the estate tax. It can also be as a gift to heirs. By converting your traditional IRA to a Roth IRA, the owner can pay the taxes at a lower rate (someone well into their retirement years is conceivably paying less than their heirs who would probably be in their prime working years).

Perhaps the best period to convert is just after retirement but before social security kicks in for a conversion of the bulk of the funds. Retirees could have enough in their checking/savings at retirement to not have to start withdrawing funds from retirement accounts and conceivably avoid paying a huge chunk of taxes the first year by converting to a Roth. They may have little to no income other than the conversion amount and therefore would avoid paying taxes on a large portion of it.

This visual by Nerd's Eye View is a good way to visualize it:

How To Convert

You have two available paths to conversion:

  • Trustee-to-Trustee Transfer. The easiest method and it prevents the possibility of the 60-day window expiring and paying a tax penalty. Most sites like Fidelity or Schwab have online transfers where you work through the steps to complete the conversion. They also have reps there to help you with any questions you may have. This can be done within the trustee itself or between two different trustees.
  • 60-Day Rollover. Just like a 401(k) rollover to a traditional IRA, you can receive a check for the balance of your account and then roll them over into a Roth IRA account; And just like with a 401(k) rollover, you must do so within 60 days of the distribution. If you don’t, the amount of the distribution (less non-deductible contributions) will be taxable in the year received, the conversion will not take place, and the IRS 10% early distribution tax penalty will apply.

Should You Convert

This is the $64,000 question. As mentioned earlier, deciding on keeping a Tradition IRA or converting to a Roth basically depends on your future tax situation. In effect, you’re trying to determine whether the tax rate you pay on your Roth IRA contributions today will be greater or smaller than the rate you’ll be paying on distributions from your Traditional IRA after you’ve retired (or have to start making them, at age 70½).

Since it's next to impossible to predict the future federal and state rates decades from now, all you can do is guesstimate that since federal rates are historically low and that the deficit continues to rise, federal rates have a higher probability of increasing over the long term. This would indicate that Roth IRAs are the way to go.

However, there is more to it than that. The questions someone would ask themselves is:

  1. What is my current tax situation?
  2. What do I expect my future tax bracket to be? Is that higher or lower than my current one?
  3. Will my annual income increase or decrease?

The generic response is that you will continue to increase in income during your working years, followed by a significant drop in gross income at retirement. This may not be the case for everyone. As we will show in a future article, there are many activities in retirement that can produce income. Also, retirees will start collecting social security and pensions, which are most likely taxable as well.

Lastly, as you get older, you may start to lose many tax deductions such as mortgage interest, property tax deductions, child tax credits, and so on, which may pop you back into a higher bracket even though you are taking in less gross income than before retirement.

Many brokerage firms like Fidelity, Schwab, and Vanguard have conversion calculators that can help determine if it is right for you. Simply input the information and they will calculate based on the parameters you supply if conversion is right for you.

Here is an example I created using Fidelity's calculator:

Age: 40
Spouse Age: 40
Residence: NY
Est. Total Income: $150,000
Total Taxable Income: $112,000 (after tax deductions)
Account Balance: $300,000
Conversion Amount: $150,000
Estimated Future Tax Bracket: 25%
Years From Conversion to Withdrawal: 25 Years
Years From Retirement to Death: 25 Years
Investments: 85% Stocks, 15% Bonds

(Source: Fidelity)

Conclusion:

Everyone has different circumstances regarding their retirement plans and the investments that will fund them. So it is always best to consult a financial professional that knows their particulars to better tailor a strategy that meets their needs. Tax alpha or retirement income planning that seeks to reduce taxes payable during retirement years is an often misunderstood and ignored aspect of planning. Many investors can save significant tax dollars that are not fully incorporated into returns when assessing their retirement plans.

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