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Is Converting to a Roth IRA a Good End-of-Year Tax Strategy?

December 03, 2013

Investors who are working to grow their retirement wealth may consider converting by the end of the tax year.

Roth IRAs can offer a great deal more flexibility than Traditional IRAs, and many investors who are working to grow their retirement wealth may consider converting to the former by the end of the tax year.

With the elimination of a 2010 rule that precluded investors with a modified adjusted gross income of more than $100,000 from converting to a Roth, more individuals of all income brackets have begun seriously considering conversion. Some benefits of a Roth IRA include:

  • Tax-free withdrawals
  • No age-based distribution requirement
  • Investors can make contributions past age 70½
  • Required minimum distribution does not apply to a Roth IRA
  • Investors can leave an income-tax-free Roth IRA to heirs for gift and estate-planning purposes

While a Roth may provide a number of advantages, conversion is not always the best decision in every circumstance, and those considering the move should fully understand your own tax position and goals before doing so.

There are several benchmarks investors should consider to determine if they would earn considerable gains through converting a traditional IRA to a Roth IRA, the most important of which being their future projected tax rate. Listed below are several initial questions investors should ask themselves to gain more insight into their decision:

  • Do I expect my retirement tax rate to be equal or higher than it is today?
  • Do I have the outside financial resources to pay income taxes on the conversion?
  • Do I file as single, head of household or married filing jointly on my tax return?

If the answer to all of these questions is “yes,” investors should delve further into the benefits of a Roth conversion. If the answer to any of these was “no,” it’s important to understand the reasons why a conversion may not be the best course of action.

Roth IRAs are best suited for investors who anticipate being in a higher tax bracket in the future and during retirement because the conversion allows them to essentially lock in their current tax rates to avoid paying a higher rate during retirement. On the opposite end, individuals who are already in a high tax bracket and convert to a Roth are gambling on future rates they will pay when they begin taking withdrawals.

Conversion costs

Another commonly overlooked factor is whether investors have the financial means outside of their IRA accounts to pay income taxes on the conversion. Investors who pay the taxes directly from their IRA lose out on the potential benefit of tax-free growth on that amount, essentially reducing the long-term benefits of the conversion.

Those under age 59½ who withdraw IRA funds to pay the tax would also be subject to a 10 percent early withdrawal penalty, as well as potential state taxes. Investors who sell appreciated assets to pay the conversion tax could also face additional capital gains tax, thereby reducing any conversion gains. Finally, investors who have cash on hand to cover conversion costs must weigh the “opportunity cost” of what the money could have earned if invested.

Other factors to weigh

Even if all of the eligibility rules are met by investors, conversion may yield unexpected results. For instance, amounts being converted, when added to investors’ current year’s income, may trigger tax consequences that include moving them into a higher tax bracket or subjecting them to taxes they otherwise wouldn’t pay, such as Social Security benefits and higher Medicare premiums. In 2013, single filers with more than $200,000 in adjusted gross income could be liable for the 3.8 percent Medicare surtax.

The potential benefits of Roth conversions vary on a case-by-case basis, making it important for investors to work closely with a financial professional who can review their unique circumstances.

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