• February 1, 2023

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Many people wait until near the end of the year to consider whether to convert a traditional IRA to a Roth IRA. But traditional IRA owners should be alert throughout the year for good opportunities to convert all or part of an IRA.

Many variables determine whether a conversion will pay off or not, and I always recommend using software that considers all or most of the variables and lets you can change them to see the results in different scenarios and assumptions.

There are events and situations that are likely to increase the benefits of a conversion. IRA owners look for these and, after spotting one, do an in-depth analysis of whether a conversion makes sense.

In a conversion, assets are rolled over from a traditional IRA to a Roth IRA. The converted amount is taxed as a distribution, so the rolled over amount is included in the IRA owner’s gross income for the year and taxed as ordinary income.

Income and gains compound tax free in the Roth IRA. After the owner has had any Roth IRA opened for at least five-years, all distributions are tax free. Distributions to beneficiaries who inherit a Roth IRA also are tax free.

Required minimum distributions (RMDs) that apply to owners of traditional IRAs don’t apply to the original owner of a Roth IRA.

The optimum time to consider a conversion is after the working years are over but before Social Security benefits and RMDs have begun. During this period, the individual is likely to be in a lower tax bracket than during the working years, doesn’t have to take an RMD before doing the conversion, and has no risk the conversion will increase income taxes on Social Security benefits.

Another good time to consider a conversion is after the IRA’s value has declined due to market changes. Because of the lower value, the same number of shares of stocks or funds can be converted at a lower tax cost than at the start of the year. When you believe the values will rebound over time, you’re converting the future gains into tax-free income at a discount.

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The best candidates for conversions are those who have enough income and assets outside the traditional IRA that they won’t need RMDs to pay for retirement expenses. For them, RMDs will be nuisances that increase their income taxes, trigger higher taxes on Social Security benefits, increase the Medicare premium surtax, and cause other problems.

People in this situation should consider converting a portion of their traditional IRAs to reduce their future RMDs. While it’s preferable to convert before RMDs begin, conversions after the beginning date for RMDs still can be profitable.

The higher a person’s net worth and IRA balance, the more likely it is that a conversion will pay off. For them and others, a conversion is an excellent estate planning tool. The IRA owner essentially pays the income taxes for the heirs, yet it doesn’t count as a taxable gift.

Shifting the traditional IRA to a Roth IRA avoids dumping tax problems on the beneficiaries.

Conversions usually are the most effective when they are done over a period of years. You generally want to avoid converting so much in one year that it pushes you into the next higher tax bracket, triggers taxes on your Social Security benefits, or increases your Medicare premium surtax in two years.

It’s important to consider more than current and future income tax rates. You want to know if the conversion might trigger any Stealth Taxes (such as higher Medicare premiums and taxes on Social Security benefits) and factor those taxes into the cost of the conversion.

How the Roth IRA will be invested influences the potential benefit of a conversion. The higher the investment returns of the Roth IRA, the more you’ll benefit from the conversion. It might not make sense to convert when the Roth IRA will be invested very conservatively. You want the Roth IRA to hold your assets with the highest potential returns, so you’ll be maximizing the future taxes that are avoided.

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