Roth IRA Conversion: Does it Make Sense?
- You can convert a portion of your traditional IRA into a Roth IRA and enjoy tax-free withdrawals after retirement. A conversion might not be right for everyone.
- Your future tax bracket, your time horizon, your plans for your estate and whether or not you have cash on hand to pay the conversion tax may all figure into your decision.
- There are other things to consider when thinking about conversion, such as the traditional IRA aggregation rule and recharacterization.
In an effort to increase present-day tax revenue, Congress has made Roth IRA conversions available to a greater number of individuals over the years by removing income caps and expanding eligibility.
So should you convert your traditional IRA to a Roth IRA? Tax planners generally advise against paying a tax today that you can defer until later, but there are circumstances where you could be better off paying taxes in the present day. Before looking at the pros and cons of conversion based on your unique situation, here’s a brief recap of the basics:
Traditional IRA vs. Roth IRA
- Traditional IRA: Money put into a traditional IRA is generally tax-deductible, with some limitations. If you're an active participant in a qualified employer plan like a 401(k) you're subject to "phase-outs," or income restrictions. This means that the amount you can deduct from your taxes phases out as your income climbs from the bottom to the top of an IRS-set range.
Married with nonparticipant spouse**
* Assumes joint filing, with both spouses participating in employer-provided plans.
** Assumes joint filing, with only one spouse participating in a qualified retirement plan. Limit applies to nonparticipant spouse.
Even though traditional IRA distributions are taxed at ordinary income tax rates, it can still make sense to contribute if you are eligible to receive an up-front deduction. However, because long-term capital gains and qualified dividend tax rates are currently lower than ordinary income tax rates, a nondeductible contribution to a traditional IRA rarely makes sense. There's no up-front deduction and earnings are eventually taxed at higher ordinary income rates when withdrawn. If you're not eligible to deduct your traditional IRA contribution or contribute to a Roth IRA, then it’s usually better to invest tax-efficiently in a regular brokerage account so you can take advantage of lower long-term capital gains rates.
- Roth IRA: With a Roth, contributions are not tax-deductible, but earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years. And you don't need to take required minimum distributions (RMDs) starting at age 70½, as you do with a traditional IRA.
Married filing jointly
The maximum individual contribution for both 2016 and 2017 to a traditional or Roth IRA, regardless of filing status, is $5,500 ($6,500 if you're 50 or older). You can choose to contribute to either type of account or to both; however, your total contribution cannot exceed the maximum. The deadline to make your contributions for the previous tax year is April 18 of the following year.
So, if you qualify for a deductible traditional IRA and a Roth IRA, which one makes the most sense?
While facts and circumstances may vary, here are some rules of thumb to help you choose wisely:
- If you have many years to go before you'll need to withdraw the money in retirement and you think your income tax bracket will be the same or higher when you retire than it is today, then a Roth IRA probably makes sense. For example, a Roth can be especially attractive for younger workers who are far from their peak earning years.
- If you think your income tax bracket will be lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. See income tax brackets here.
Roth IRA conversion
If you’re not eligible to contribute to a Roth IRA and your employer’s plan doesn’t allow you to make Roth-designated contributions to your 401(k) plan, then another way to take advantage of a Roth IRA's potential benefits is to convert some or all of your traditional IRA money to a Roth.
Even though you have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:
You think you will be in the same or a higher tax bracket when you withdraw,
You have a long time horizon, and
- You can pay the tax from sources other than your IRA, such as regular taxable brokerage or bank accounts. (See the additional notes about paying the conversion tax below.)
- You don’t need to use the money and want to leave an income-tax-free Roth IRA to your heirs for gift and estate-planning purposes.
A few important notes about paying the conversion tax:
If you pay the tax from your IRA, you lose the potential benefit of tax-free growth on that amount, defeating the purpose of converting.
If you’re under 59½, withdrawing money to pay the tax would be an even worse idea, since you would also incur a 10% federal penalty. (State penalties may also apply.)
Ideally, you will have cash on hand to pay the income tax. If you need to sell appreciated assets to pay the conversion tax, the additional capital gains tax reduces the benefits of a Roth conversion.
- Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the opportunity cost—or how much money you could have earned had it remained invested in a taxable account.
A hypothetical example
Here, we estimate the dollar advantage or disadvantage of converting $1,000 from a traditional IRA to a Roth IRA. We assume a current income tax rate of 25% and a 6% average annual return. As you can see from the table below, a future retirement tax rate equal to or higher than the current tax rate favors the Roth conversion. A lower future tax rate favors leaving the money in a traditional IRA.
Additionally, the longer the time horizon, the greater the advantage (or disadvantage) of the conversion.
Advantage or disadvantage per $1,000 of conversion
(Current tax rate=25%, average annual rate of return=6%1)
Future tax rate
Time horizon (years)
Note that a Roth conversion has a slight advantage even if the future tax bracket remains the same. That’s because we assume current taxes will be paid from taxable accounts and the full conversion amount will go into the Roth. If taxes were paid from the IRA at the time of conversion, then there would be no advantage or disadvantage no matter how long the time horizon, assuming the future tax rate is the same.
For example, consider the following scenario:
Traditional IRA balance = $1,000
Current federal income tax rate = 25%
Future federal income tax rate = 25%
If you pay the conversion tax using IRA funds, you are left investing $750 in your Roth. (You'll have even less to invest if you're younger than 59½ at the time of conversion and use IRA funds to pay the tax, since you'll also incur a 10% federal penalty, and possibly state penalty and taxes.) Assuming an initial investment of $750 and an average annual return of 6%, after 20 years you'll have $2,405 in your Roth.
If you left your traditional IRA alone and earned the same return, you would have $3,207 after 20 years. Assuming the same tax rate of 25%, you would end up with exactly the same amount after withdrawing the money and paying $802 in federal income taxes: $2,405.
Keep in mind that the higher your Roth balance, the greater the potential advantage. That's why it's important to pay the conversion tax from outside funds, if possible. Of course, you still need to account for the opportunity cost of taxes paid with outside funds, since that money could have been invested all along if you'd simply left your traditional IRA alone.
However, as you factor in the hypothetical opportunity cost in your analysis, remember that the ongoing return lost to taxes each year and long-term capital gains tax at liquidation of this hypothetical account are likely less than the ordinary tax rate you would incur on a future withdrawal from a traditional IRA. That's why there will be a slight advantage with the Roth conversion even if the future tax bracket remains the same.
Who benefits the most from a Roth conversion?
The primary reason for Congress expanding Roth conversion eligibility was to accelerate the collection of income taxes that might have otherwise been locked up in traditional IRAs or 401(k)s for decades to come. But, who is most likely to gain from this change, besides the U.S. Treasury? Taxpayers who are in the lower tax brackets now (i.e., younger workers yet to reach peak earning years) could benefit the most from a Roth conversion.
Taxpayers in the top brackets might find the projections less compelling because the chance that they will be in the same or a higher bracket after retirement is lower. Nevertheless, if you’re in the highest brackets and expect to stay that way throughout retirement, it could still make sense—especially if you believe tax rates will increase in the future.
Income taxes aside, very high-net-worth individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime. Though the value of a Roth will still be included in the gross estate, because there are no RMDs, the account could grow larger than it otherwise might under traditional IRA distribution rules—leaving more for heirs to withdraw income-tax-free over their lifetimes.
What's more, the income tax paid at the time of conversion (preferably with cash) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift.
Finally, retirees with large traditional IRA balances might also benefit from converting a portion of their traditional IRAs in years prior to age 70 1/2, to the extent that doing so helps mitigate the taxability of future required minimum distributions.
Here are three more caveats to consider:
- Traditional IRA aggregation rule: If you have made nondeductible contributions to your traditional IRA in the past (hopefully, recorded on IRS Form 8606), you can't pick and choose which portion of the traditional IRA money you want to convert to a Roth. The IRS looks at all traditional IRAs as one when it comes to distributions, including Roth conversions. Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money. For more on the aggregation rule, see IRS Publication 590.
- Converting nondeductible IRA contributions to a Roth: Since 2010, high earners otherwise not eligible to make Roth contributions can make nondeductible contributions to a traditional IRA and then convert those amounts to a Roth. This process could be repeated every year, unless Congress eliminates this option in the future.
- Recharacterization: You can recharacterize—or reverse—a contribution or conversion any time up to the income-tax-filing deadline, plus extension, for the tax year of the conversion. For example, if you converted in the 2016 tax year, you can recharacterize as late as October 15, 2017. If you recharacterize a Roth conversion and later change your mind, you can’t reconvert back to a Roth until the following year (for example, 2017 or later if you converted in 2016), and you must wait 31 days after the recharacterization (no reconversion is allowed within 30 days of the recharacterization).
NOTE: Under current law, there is no recharacterization provision for 401(k) conversions.
The bottom line
Eligibility for a Roth conversion doesn't automatically make it a good idea. That said, under the right circumstances, converting to a Roth IRA can have significant benefits. Conversion for estate-planning purposes may also add value.
Each situation needs to be evaluated on a case-by-case basis. Take a close look at your own situation and, if it makes sense, consider taking advantage of these rule changes. Remember that tax laws are subject to change, so stay current at www.irs.gov. Also, be sure to talk with your accountant or other professional tax advisor about whether converting to a Roth makes sense for you.
Finally, we realize that the decision to convert is complex. If you have additional questions about Roth IRA conversion, call a Schwab investment professional at 800-424-5750 to talk about your particular situation.
I hope this enhanced your understanding of Roth IRA conversions. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
1 Table shows the difference between the projected future value of the Roth minus traditional IRA. Note that we also subtract an opportunity cost from the Roth projection, assuming the conversion tax paid from taxable accounts would have been invested with a return of 6%, but would lose some return to ongoing taxation, as well as a 15% long-term capital gain tax on the adjusted cost basis at liquidation.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.