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A Conversation About Conversions

A Conversation About Conversions

Part 1 of this blog went over the basics of Roth accounts, while Part 2 covered the pros and cons of backdoor Roth IRAs. If you missed either one, you can find Part 1  here and Part 2 here. If you like the idea of tax-free growth for retirement, another strategy to consider is doing a Roth conversion, where you choose to move savings from a pre-tax retirement account to a Roth account for the purpose of future tax savings.

The General Idea
The IRS currently allows for a conversion of pre-tax retirement savings to a post-tax Roth account, without any caps on the amount of the conversion or any income limits on eligibility (for now, anyway). This conversion is typically fully taxable, in other words the full amount of the pre-tax conversion is taxed in the year of conversion. This tax impact can be painful if the investor is converting a large amount or if they are in a high tax bracket, or both. Also, if the investor is under 59 ½, they may want to consider paying the taxes from another source because drawing from the retirement accounts to pay the tax would incur an additional 10% early withdrawal penalty. However, despite these drawbacks, there are some benefits that could make a Roth conversion attractive. First, the proceeds of the conversion will then grow tax-free until withdrawal so this protects the investor from the risk of increasing tax rates over time. Second, there are no Required Minimum Distributions (RMDs) from a Roth account at any age, so there is more flexibility on when to take withdrawals, if ever.

It is worth thinking strategically about when to execute a Roth conversion in order to optimize the results. The tax impact of the conversion will be less in a year where the investor has a lower income, or when they happen to have losses or deductions to offset the additional tax. It might also be wise to execute the conversion at a low point in the market (e.g. after a large drop) to minimize the taxes and hopefully see the rebound in the market occur in the tax-free Roth account. Another consideration would be if the investor knew they were eventually moving to a state with higher income taxes, it might make sense to take the tax hit before the move.

Potential Legislation
The Build Back Better (BBB) legislation that was being discussed in Congress late last year included a provision that would put an income limit on Roth conversions. The income limit was fairly high ($400K for single filers and $450K for married filing jointly), and the effective date was not until 2030. However, since the BBB legislation did not pass, it is unclear how the treatment of Roth conversions could change going forward. It is possible that the BBB legislation could still pass in some form in 2022, but it is worth watching whether this provision is included and what the effective date of any change will be.

Disclosure: Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

Neil Manning, CFP, AIF, CDFA, FSA

I am a reformed actuary turned financial advisor, helping my clients with everything from investments to retirement projections to LTC insurance since 2014.  Unlike most normal people, I love numbers and finance – I’m currently reading a book about game theory which my wife and two teenage daughters think is unbelievably boring (they are wrong).  For more details about my background, check out my website below.

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