Converting a traditional IRA to a Roth can shield your retirement savings from future tax increases, but there are pitfalls and trapdoors, too. You’ll owe taxes on a conversion, and the up-front tax bill could be higher than you expected—particularly if the conversion pushes you into a higher tax bracket. If your income tax rate drops significantly after you retire, the tax advantages could be modest or nonexistent. And as with any financial transaction that intersects with the tax code, you—or your financial adviser—must comply with multiple rules and regulations to avoid running afoul of the IRS.
Because many people, including retirees, believe taxes will rise in the future, Roth conversions are “trendy,” says Evan Beach, a certified financial planner with Campbell Wealth Management, in Alexandria, Va. “But you see people get over enthusiastic about it, and they don’t know what they’re doing.”
Until recently, if you converted an IRA to a Roth, the law let you have a do-over. Before 2018, taxpayers who converted an IRA to a Roth had until the tax-extension deadline—typically October 15—of the year following the year they converted to change their minds. If you discovered after the fact that you couldn’t pay taxes on the conversion, you could simply put the money back into your traditional IRA and go about your business. Likewise, if the value of your IRA dropped significantly after you converted, you could undo the conversion and avoid paying taxes on phantom income.
The Tax Cuts and Jobs Act eliminated this option, so make sure you’re prepared to pay the tax bill before you take the leap. Fortunately, nothing in the law says you must convert your entire IRA at once, and for many people, a series of partial conversions over several years is one of the most effective ways to avoid regrets.
THE SWEET SPOT FOR CONVERSIONS
A refresher: When you convert money in a traditional IRA to a Roth, you must pay taxes on the amount you convert (although part of the conversion will be tax-free if you’ve made nondeductible contributions to your IRA). There are no age or income restrictions on Roth conversions.
Once you’ve converted, all withdrawals are tax-free as long as you are 59½ or older and have owned a Roth for at least five years. Unlike traditional IRAs and other tax-deferred accounts, Roths aren’t subject to required minimum distributions at age 72. So if you don’t need the money, you can let it continue to grow, tax-free.
Older retirees were particularly enthusiastic about Roth conversions in 2020 after Congress enacted the coronavirus stimulus package, which, among other things, allowed retirees who were 72 or older to skip required minimum distributions for the year. Ordinarily, retirees who are 72 or older can’t convert money in a traditional IRA (or other tax-deferred accounts) to a Roth until they’ve taken their RMDs—which could result in a hefty tax bill. With the minimum distribution requirement waived, retirees could convert money directly to a Roth, and many did. The waiver was set to expire on December 31, and it’s unlikely Congress will extend it. So if you’re 72 or older and converting in 2021, you need to be mindful of the costs of converting.
That’s why many planners believe the period between the time you retire and the time you turn 72 is the sweet spot for Roth conversions. There’s a good chance your income will drop after you stop working, and until you are required to start taking distributions, you have some control over the amount of income you receive each year. That will help you lower the tax bill on your Roth conversion.
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