Roth conversions are a means of paying the taxes on retirement accounts that are currently tax-deferred. Tax-deferred means I am not paying taxes now and I will have to pay taxes in the future. Roth conversions allow you to pay taxes based on the value of the account today. In the future, the account will grow tax-free and no taxes will need to be paid on the earnings while it is in the Roth account.
It is important to note that Roth conversions are possible whether you are still working or if you are retired. To make current contributions, you must have earned income and you must be within the income limits. There are maximum contribution limits for both IRAs and employer retirement plans. There are no such limits or requirements when doing Roth conversions. You can do conversions regardless of the amount of your income and whether you are working or retired. You can convert any dollar amount that you want in any year; there is no minimum or maximum per year.
If you have a Traditional IRA, you can convert it to a Roth IRA. You will need to pay taxes on the value when the conversion is done. You can convert part of an account. Do not shy away from doing a conversion because the Traditional IRA contains a significant dollar amount.
How much should you convert at a time? We start by looking at three criteria to determine how much to convert in a given tax year:
1. What dollar amount can be converted without increasing the tax rate that you will pay on the conversion? In most cases, it makes sense to convert only the amount that causes your taxable income to go to the top of the current tax bracket.
2. Ideally, you will pay the taxes with funds outside the IRA funds. How much cash do you have available? If, for example, you only have $3000 or $7500 of available cash, you want to determine the amount that you can convert for that cash availability.
3. The third consideration applies if you are over 65 and paying Medicare premiums. The monthly amount you pay for Medicare premiums goes up as your income goes up. There are Medicare premium brackets like there are tax brackets. We want to attempt to not increase your Medicare premiums by going to the next Medicare bracket.
As an example, consider a married filing joint couple, both over age 65 with a pension, taxable Social Security and investment income of $125,000. The $125,000 is their adjusted gross income (AGI). Subtracting the standard deduction of $27,000 would give us a taxable income of $98,000.
1. The top of the 22% tax bracket in 2019 is at a taxable income of $168,400. You can convert up to $70,400 before income would be taxed at the next tax rate of 24%.
2. If we did a $70,400 conversion at a tax rate of 22%, the tax amount due would be $15,488. Do you have the cash available to pay in that tax amount? If you only have $5000 cash available, we will limit the conversion to approximately $23,000.
3. For a married taxpayer, the first increase in the Medicare premium bracket occurs at an AGI of $174,000. Adding a conversion of $70,400 to an AGI of $125,000 would make the new AGI $195,400. To avoid an increase in Medicare premiums, we would limit the conversion amount to $49,000. That would keep the AGI at the $174,000 for the Medicare premiums to stay the same.
Applying these three criteria helps determine the amount of IRA money to convert and avoid paying taxes at a higher tax rate or higher Medicare premiums than what you are currently. There are reasons that you may want to consider paying higher taxes or Medicare premiums for a year to convert more.
There is the consideration of the more years I take to convert, the more taxes I may have to pay. The Traditional IRA account value continues to grow while I take more time to do the conversions. This means paying more in taxes over more years because I have a larger dollar amount to convert. There are other reasons also. While not an all-inclusive list; you may want to consider:
• Investment account values are down right now, allowing you to convert more shares. When your investment values increase, that growth is in the tax-free Roth IRA rather than the taxable Traditional IRA.
• You want to reduce future required minimum distributions (RMDs).
• You want to get more dollars converted before you start paying Medicare premiums, before you start collecting Social Security, before you turn age 72 and must start RMDs.
• You are anticipating a significant change to your income in the future and want to know the taxes are paid – retirement, getting married or divorced, terminal illness, partial unemployment in the current year, the ability to impact the amount of taxable Social Security, etc.
• The potential impact on your estate and estate planning, especially with the loss of a stretch IRA option.
If you have a Traditional IRA, those funds are available for conversion. Most employers will not allow you to convert pre-tax dollars while the funds remain in the employer plan. Do you have 401(k), 403(b), 457, or other previous employer’ retirement accounts? These can be moved from the employer’s account into a Traditional IRA and then converted. Some employer plans allow you to make an in-service withdrawal, which means you can take funds out of the plan even while you continue to work for the employer. An in-service withdrawal would allow you to roll the funds to a Traditional IRA to do a conversion.
You may have to wait until you retire or leave the employer before having an ability to convert. Making sure current dollars going into retirement are going into a Roth account may be the only option you have. This may be funding a Roth 401(k), 403(b) or 457 if your employer offers that option. This may mean funding a Roth IRA outside of your work-based plan. This may be funding a non-deductible Traditional IRA and doing a conversion to get the dollars into a Roth IRA.
