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Why Consider a Roth IRA Conversion and How to Do It

Does it ever make sense to pay taxes on retirement savings sooner rather than later? When it comes to a Roth Individual Retirement Account (IRA), the answer could be yes.

That’s because, although a Roth IRA is funded with after-tax dollars, qualified withdrawals are entirely tax-free.1 What’s more, Roth IRAs aren’t subject to the required minimum distributions (RMDs) the IRS mandates you take from most other retirement accounts once you reach age 70½, giving you greater control over your taxable income in retirement.

Can anyone contribute to a Roth IRA?

One hitch is that you can’t contribute to a Roth IRA in 2019 if your modified adjusted gross income (MAGI) equals or exceeds certain limits ($137,000 for single filers and $203,000 for married couples filing jointly). There’s a workaround: A Roth IRA conversion allows anyone, regardless of income level, to convert existing traditional IRA funds to a Roth IRA.

Should you convert to a Roth IRA?

You must pay income taxes on any converted funds in the year of the conversion, but there are four scenarios in which that might be to your advantage to do a Roth IRA conversion:

  1. You believe your tax bracket will be higher in retirement: In this scenario, paying taxes at your current tax rate is preferable to paying a higher rate after you’ve stopped working. This may sound farfetched, but it isn’t particularly difficult to do, especially if you haven’t yet hit your peak earning years or you’ve accumulated significant savings in your retirement accounts. It could make sense to convert all or a portion of funds in a traditional IRA to a Roth today and not in the future.
  2. You want to maximize your estate for your heirs: If you don’t need to tap your IRA funds during your lifetime, converting from a traditional IRA to a Roth allows your savings to grow undiminished by RMDs, potentially leaving more for your heirs—who can also benefit from tax-free withdrawals during their lifetimes.
  3. You have the ability to pay for the conversion.  Ideally, you will want to pay for the taxes with money held outside of the IRA amount that you are converting.  In other words, paying the taxes from a taxable account. 
  4. You understand that you can no longer “undo” a Roth conversion.  This was a recent change under the Tax Cuts and Jobs Act of 2018.  Under this new rule you can no longer “recharacterize” or undo a Roth conversion. Once you convert, there’s no going back.

The decision to convert to a Roth IRA doesn’t have to be all or nothing. You may find dividing your savings among a Roth and traditional IRA and/or a Roth and traditional 401(k) is the optimal solution.

How do you convert to a Roth IRA?

If you do decide a Roth IRA conversion is right for you, you’ll need to determine two things:

  1. When to execute the conversion: If you have a significant balance in your traditional IRA, you may want to carry out multiple Roth IRA conversions over several years. For example, you might convert just enough to keep additional distributions from being taxed at the  next tax bracket. If done properly, a multiyear approach could allow you to convert a large portion of your savings to a Roth while limiting the tax impact. Early in retirement—when your earned income drops but before RMDs kick in—can be an especially good time to implement this strategy.  One issue to be mindful of is making Roth conversions when you are close (within about 2 years) to filing for Medicare and Social Security. A Roth conversion can increase your Medicare premiums and increase the taxes you pay on Social Security benefits.
  2. How you’ll pay the resulting tax bill: We recommend paying with cash from outside your IRA for a couple of reasons:
  • Any IRA money used to pay taxes won’t be accumulating gains tax-free for retirement, undermining the very purpose of a Roth IRA conversion.
  • If you sell appreciated assets to pay the conversion tax, capital-gains taxes could further undermine the benefits of a conversion. Plus, if you’re under 59½ and withdraw money from a tax-deferred account, you’ll incur a 10% federal penalty (state penalties may also apply).

In short, converting to a Roth IRA can give you greater flexibility to manage distributions from your retirement savings and the potential to cut your tax bill in retirement, but be sure to consult a qualified tax advisor and financial planner before making the move.

1Qualified distributions are those that occur at least five years after the account is established. At least one of the following conditions must also be met: the account holder is 59½ or older at the time of withdrawal; the account holder is permanently disabled; distributed assets (up to $10,000) are used toward the purchase or rebuilding of a first home for the account holder or a qualified family member; or withdrawals are made by the account beneficiary after the holder’s death.

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Important Disclosures

This information 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 that you consult with a qualified tax advisor, CPA, financial planner or investment manager.

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.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, their accuracy, completeness and reliability cannot be guaranteed.

Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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