Siller & Cohen’s Wealth Unpacked Blog: Roth IRA’s (Part 2): Conversions

By Siller & Cohen on June 21, 2023

What is a Roth IRA Conversion?

A Roth IRA conversion involves taking a traditional retirement account, such as a traditional IRA or 401k and moving that money into a Roth IRA. You’ll have to pay income tax on the amount converted but if you meet certain rules, you won’t pay any tax when you eventually withdraw the funds.

Unlike a Roth contribution, there are no income limitations to do a Roth conversion. Anyone can do it.

Who Should Consider doing a Roth IRA Conversion?

• You should consider converting if you believe that your investments will grow over time. You’d be trading off paying income taxes early on a smaller value and saving income taxes later, on a larger value based on whatever it grows to be. The longer you leave the funds growing the better. In fact, this can be a terrific strategy if you are planning on leaving the funds for your heirs.
• If you want to hedge against rising tax rates: Individual tax rates are near historic lows and the federal deficit is rising. Also, the current low-income tax rates are set to expire at the end of 2025. So, it might make sense to convert some of your retirement funds in these low tax years.

If you are in an unusually low-income year and expect your income to go up, you should run the numbers and maximize your lower tax brackets.

In fact, with some of our clients we have recommended doing partial conversions over several years. This allows them to manage their tax brackets to avoid paying taxes at the highest federal and state tax brackets. This would allow the conversions to cost less in taxes than if converted all at once.

Note: We’ve run some analyses which show that a Roth conversion can also make sense even if you don’t expect your income tax rate to change in retirement.

• If you want to better control your taxes in retirement you should consider a partial conversion as a tax diversification strategy: By leaving some retirement dollars in a traditional IRA, or 401k plan and only converting some into a Roth IRA, you can manage your taxable income later. That’s because traditional accounts will generally be subject to required minimum distributions at age 73, while a Roth IRA is not subject to RMD, so no money is forced out.

By controlling your taxable income in retirement, it may help you control:

   a.  Your marginal tax brackets

   b.  Increases in Medicare premiums

   c.  Higher hurdle rates for certain itemized deductions

• Other Considerations:
  • You are moving from a state with no or lower income taxes to a state with a high-income tax. Roth conversions are subject to state tax so consider a conversion before you move.
  • Converting to a Roth may make sense during a year when you have tax losses or will be making substantial charitable donations to offset the additional income tax liability from the conversion.
• Note: It is important to pay any taxes for a conversion from funds sitting outside of retirement plans, so you are not paying taxes on dollars used to pay the conversion tax.

Opportunity To Access Your Retirement Funds Under Age 59 ½ Penalty Free

When you do a Roth IRA conversion there are two 5-year rules to be aware of:

The first 5-year rule relates to the converted amount, the amount you paid tax on. If you withdraw the converted funds within 5 years of the conversion, there is a 10% penalty unless you are at least 59½ or meet another exception. This is where the planning opportunity comes in, because once you’ve left the money in for 5 years you can remove the entire balance, even if you are under 59 ½ and there’s no penalty!

If you have multiple conversion events (i.e., you partially convert in 2023 and then do another partial conversion in 2025, each conversion amount has its own 5-year clock ticking.

Example: Let’s look at someone age 45 who decides that they need money from their Traditional IRA before they reach 59 1/2, but they don’t want to pay the 10% penalty on early withdrawals. If they simply wait for the 5 years to pass after conversion, they can take as much as 100% of the converted principle out. As they’ve already paid income tax, there will be no tax due, and as they’ve waited 5 years, there will be no 10% penalty due. So, this 45-year-old was able to access all their principal at age 50, instead of waiting almost another 10 years! 

Timing Is Everything

I mentioned two 5-year rules. The second 5- year rule, discussed in our first Roth IRA blog,relates to earnings and growth on the converted amount. To avoid income tax on distributions of earnings and growth from a Roth IRA you must meet 2 requirements:

• The distribution must be made at least 5 years after the conversion and
• The Roth IRA owner must be at least 59 ½ or meet one of the other limited exceptions

To determine whether funds distributed from a Roth IRA are from the converted amount or from earnings and growth the IRS has ordering rules, and they happen to be favorable for the taxpayer:

1. After Tax Contributions-The first moneys that come out a Roth IRA are considered contributions. We discussed on our first Roth video how contributions may be distributed any time income and penalty tax free.
2. Converted Principal-The second moneys that come out are considered converted funds. As we’ve discussed, those funds have already been subject to income tax so the only issue is whether they will be subject to the 10% penalty tax. If you meet the 5-year rule or are age 59 ½ or older, or meet one of the other exceptions, the penalty doesn’t apply.
3. Earnings and growth-Their considered distributed last. To be income tax and penalty tax free, 2 requirements must be met: The funds must have been in the Roth IRA for at least 5 years and the owner must be age 59 ½, unless one of the other exceptions apply.

Summary

A Roth IRA Conversion can be a powerful strategy if you have enough nonretirement funds to pay the taxes due because of the conversion. While this strategy can be used to access funds penalty free before you reach age 59 ½ (if you meet the 5-year rule), it is most powerful if you won’t need the funds for a long time. It is a terrific technique for leaving funds for your heirs.

If you are considering a Roth conversion, don’t wait too long to make your decision, get the clock started early.