Should I Convert My IRA to a Roth?

Should I convert my IRA to a Roth IRA? If so how? When?

Roth Conversions may save you tens or hundreds of thousands of dollars over your lifetimes! Or they may cost you the same. With such high stakes, and the 2022 Roth Conversion Deadline less than two months away, let’s explore Roth conversions.

Most tax preparers don’t know enough about financial planning or your situation to give you good advice, and most financial advisors aren’t licensed to give tax advice. I’ve heard of people who have asked their CPA if they should convert their IRA to a Roth and were told “Go ask your Financial Advisor.” Then they asked their Financial Advisor and were told, “I’m not allowed to give tax advice. Go ask your Tax Professional.”

Not helpful.

As a Certified Financial Planner and Licensed Tax Advisor, I can help you with both. Obviously, this is not tax or investment advice, but I can teach you how to know if you should do a Roth conversion and potentially avoid thousands in extra taxes. Let’s begin.

What is a Roth Conversion?

Traditional IRAs and 401(k)s are pre-tax accounts. You either put the money in before it was taxed (401(k)), or you received a tax deduction for a contribution (IRA). Most people roll their Traditional 401(k)s into Traditional IRAs, so you may have a large IRA. IRAs are pre-tax and grow tax-free. Distributions are taxable.

Roth IRAs and 401(k)s are post-tax accounts. You pay taxes on the money before it goes into the Roth. Roth accounts grow tax-free, and distributions from a Roth are generally tax-free (as long as you meet certain criteria).

A Roth Conversion is when you convert pre-tax money in an IRA to post-tax money in a Roth IRA. You move money from the IRA to the Roth and pay the taxes in the year you move it. With the taxes paid, that money will now not only grow tax-free but can be distributed tax-free.

Roth IRA Contributions vs. Conversions

There are three key differences between Roth IRA Contributions and Roth IRA Conversions.

Roth IRA Deadlines

Roth IRA Limits

Roth IRA Funding

Should I Convert My IRA to a Roth?

There are two simplistic answers to this question.

Always Convert

Some people think you should always convert. If you contributed $200,000 to the account over your lifetime, and it grew to be $1 million, would your rather:

1. Avoid taxes on $200,000 and pay taxes on $1 million (IRA)?
2. Pay taxes on $200,000 and get $1 million tax-free (Roth)?

“Pay the taxes now on the lower amount and let it grow to a higher amount tax-free.”

Never Convert

Some folks, including many CPAs, contend that you should almost never convert because it brings down your net worth. They correctly conclude that the first simplistic answer misses a key point: if you have to pay taxes on the $200,000, you won’t have $200,000 to invest, and thus it wouldn’t grow to $1 million. (Or, if you assumed you’d pay those taxes from other funds, why not avoid those taxes and put more in the IRA or other investment accounts? You’d have more than $1 million if you did traditional instead of Roth.) They look at the options like this:

1. Avoid taxes on $200,000 and have $1 million in an IRA.
2. Pay a bunch of taxes and have only $750,000 in a Roth.

“$1 million is better than $750,000, so let’s go with the higher net worth.”

But if you have $1 million in an IRA that hasn’t been taxed yet, do you really have $1 million? No. So what’s better, $1 million that has yet to be taxed, or $750,000 tax-free?

The answer: It depends on that how much taxes you’ll pay on the IRA withdrawals.

Whether you should convert your IRA to a Roth IRA depends on three factors.

Factor 1: What are the Tax Rates at Conversion and Withdrawal?

There are two options for paying taxes:

1. Pay now at conversion
2. Pay later at withdrawal

The Tax Rates now and later are the main determinant of whether you should convert.

Let’s say you have $1,000 in an IRA and you are wondering if you should convert it. The example tax rates are 25% both now and later. Should we convert? Let’s look.

	Leave in IRA	Convert to Roth
Initial Amount	$1,000	$1,000
Taxes Paid Now – 25%	$0	$250
Amount Left to Grow	$1,000	$750
Account Growth	2x	2x
Amount After Growth	$2,000	$1,500
Taxes Paid Later – 25%	$500	$0
Ending Amount	$1,500	$1,500

What? It’s the same? Yes.

If tax rates are the same at conversion and withdrawal, it does not matter if we leave it in an IRA or convert it to a Roth. This assumes you invest them identically so that the growth is the same percentage.

We know what tax rates are now. Will they be the same at withdrawal? There are two things that can affect tax rates.

Your Earnings and Spending May Put You in a Different Tax Bracket

Some people are earning a lot while working and plan to spend less in retirement. Their earnings may put them in a high tax bracket now, and their planned spending in retirement may necessitate withdrawals at a lower bracket.

Congress May Change Tax Rates

Congress can change tax rates whenever they have enough votes to do so. We don’t know what tax rates will be in the future. One thing to know, though, is that tax rates have never been lower than now. The government “gave” away trillions in Covid stimulus over the last few years (plus a declared, but not yet processed, student loan forgiveness). Do we think tax rates are going to be lower in the future? I don’t.

To Roth or Not to Roth

How do we decide based on tax rates?

If tax rates are higher at withdrawal, you should convert. Pay lower taxes now and avoid the higher tax rates at withdrawal.

If tax rates are lower at withdrawal, you should not convert. Why pay taxes at a higher amount now to avoid a lower amount later?

If tax brackets are the same at withdrawal, consider converting. If you think you will be in the same tax bracket in retirement as you are now, still consider converting. Tax rates in your tax bracket may be the same in the future. And if they are, then it won’t matter if you convert or not (all else being equal). But again, what is the greater chance: that tax rates will go up, down, or sideways? Rates would have to go down for you to be wrong on this. That’s hard to imagine.

Plus there are two more considerations for converting, one being the dreaded tax bomb.

Factor 2: What are your RMD Estimates?

Money in your IRA has not been taxed. After a while, the Government says, “Hey, you’ve been avoiding these taxes long enough. We want our money!” At age 72, they will force you to start taking money out so that they can get their taxes. These are called Required Minimum Distributions, or RMDs.

If you have enough money in your IRA, or will by the time you hit 72, these RMDs can be far more than you need and push you into a higher tax bracket.

Right now, tens of thousands of U.S. households will end up being forced to pay taxes on money they didn’t need at a higher tax bracket and likely higher rates. We call this the Retirement Tax Bomb, and it can cost you tens and even hundreds of thousands of dollars in extra taxes. We’ll pay what we owe, but let’s not leave the IRS a tip.

What’s the solution? Let’s look at the third factor first.

Factor 3: What is the Tax Impact on Social Security and Medicare?

If your taxable income is low enough, you could get your Social Security benefits completely tax-free. Your total income doesn’t have to be that low, just a certain income calculation called your provisional income. But if that income is too high, up to 85% of your Social Security can be taxed. You already paid Social Security Tax your whole life, and you could get taxed on the benefits too.

Similarly, if your taxable income is too high, you could pay a higher premium for your Medicare Parts B and D.

Your federal income tax rate in retirement isn’t the only factor that matters. The thresholds for the taxability of Social Security and extra taxation of Medicare should also factor into your calculation.

Reducing Taxes in Retirement

We lack the time to dig into how to account for Factors 2 and 3 in your calculation. And it is hard to communicate some of these things verbally. But if you want to know more about this and other ways of avoiding taxes, register for our Reducing Taxes in Retirement workshop. We run a workshop every third Thursday and November’s Workshop on taxes. It premiers online on November 17th at 6:00 PM CT. We’ll have visuals and illustrations to help better understand these tax savings strategies.

If you are a RetireMemember, you can also get the Workbook. You can join our free membership community for lots of bonus content. More on that at the end.

Register today to learn much more about saving taxes.

How Do I Convert My IRA to a Roth?

Your Financial Advisor or Custodian (such as Schwab or Vanguard) can help you with this. Conversions are direct transfers. You will electronically transfer the cash or funds from your IRA to your Roth IRA. This happens instantly for many custodians.

You will owe taxes on the conversion, both federal and state (if you live in an income-taxed state).

If you convert cash, the tax liability is easy to calculate.

If you convert funds, your custodian should give you the number of units and the trading price a the time of the conversion. From there you can calculate the amount of the conversion and subsequent taxes.

How do I Pay the Taxes on the Conversion?

You have two options for paying taxes on the conversion.

Option 1: Withhold Taxes

You can withhold taxes from the conversion. This can be handy if you are over age 59 1/2. But be warned:

If you withhold taxes and you are under the age of 59 1/2, the taxes are considered a withdrawal, not a conversion, and are subject to the 10% early withdrawal penalty.

This is a big deal that gets missed by a lot of people and even amateur financial representatives. If you are paying a 10% penalty on those taxes, you must withhold even more taxes for the penalty, and then even more taxes for that extra withholdings.

For example, if you withhold $1,000 in taxes, you will also owe $100 in penalty. So you withhold the $100, but then you owe $10 in penalties on that extra $100, and then $1 on the extra $10. In the end, you end up paying $1,111 in taxes which may undo the benefits of the conversion. It matters much more at higher conversion amounts and taxes.

If you are under 59 1/2, you likely want to use Option 2.

Option 2: Pay Taxes from Non-Retirement Accounts

Simply pay your calculated taxes on the conversion from cash you have in your bank or a brokerage account. You can submit those taxes online for Federal taxes and most if not all state taxes.

Taxes are generally due on the Tax Filing Deadline for the year of the conversion. Thus, taxes would be due in April of 2023 for converting in the fall of 2022. There’s a caveat:

You may be subject to an underpayment penalty if you owe too much on tax day due to Roth conversions. Thus, I recommend that you pay your Conversion taxes according to the Self-Employment Tax Estimated Tax Due Dates. These underpayment penalties can also be avoided without paying the taxes at conversion by paying 100% of your prior year’s tax liability (150% if your AGI is above $150,000), or paying 90% of your anticipated current year’s tax liability. These can be hard to get right, so I think it’s better to simply pay at conversion and be done with it.

You can find the Estimated Tax Due Dates and links to pay Federal and WI state Taxes here.

When Should I Convert My IRA to a Roth?

A potentially great time to convert is when equities are temporarily down in value. You can pay a lower tax bill on the same number of converted shares, and when the values recover, that recovery growth will be tax-free. And as we discussed in Episode 67, Bear Markets Aren’t Bad, if the market is down 20%, that’s a 25% recovery. That means that you may be able to pay 20% less taxes and enjoy a 25% tax-free gain. More if the decline is worse.

Technically you won’t benefit from bear market conversions if you are withholding taxes and you’ll be in the same tax bracket. It’s counterintuitive, but the math works the same as tax rates now and later.

But this works great if you are paying the taxes outside of the conversion and/or are maxing out a lower tax bracket.

Who Can Help Me With This?

If you want more information, first register for our Reducing Taxes in Retirement Workshop. That will give you more ideas and answer more questions.

This is a complicated subject, and unfortunately, most financial professionals lack the knowledge or licensure to give advice on this topic.

Tax Preparers

Tax preparers don’t know enough about your situation to give good advice. Unless you submit all your 401(k), IRA, Social Security, and other statements to your tax preparer every year, they aren’t going to be able to help. Even some CPAs who know how to figure it out can’t because they lack the information.

Financial Advisors

Most financial advisors aren’t allowed to give tax advice or don’t understand tax ramifications. A common answer you will hear from most financial advisors surrounding Roth Conversions is, “Ask your tax professional.” In most cases, their company makes them answer this way and forbids them to wade into tax advice because they aren’t licensed. (I would reconsider any professional relationship if you are bringing the ideas to them.)

Some investment advisors will recommend against Roth conversions because of their financial conflict of interest. If they get paid on the amount of assets you have with them, and they aren’t a true fiduciary, they may ignore conversion opportunities. Since you will have less money (albeit more tax-free money), there is less compensation for them. If Roth conversions are clearly a benefit and these seem hesitant to do it or reference the overall decline in your net worth, this may be why.

You may be able to get your tax advisor and financial advisor to work together, but that can be difficult.

Dually Licensed Financial and Tax Planner

If you want advice and execution from one person, find a Fiduciary Certified Financial Planner dually licensed in investments and tax advice. For example, in addition to being a CFP®, I am also an Enrolled Agent and federally licensed to give tax advice and practice before the IRS.

Every financial decision has tax implications, so I am surprised that we are so rare. As always, you are welcome to reach out to me at LaxFP.com if you want help saving on lifetime taxes.

Time is Running Out

You only have until December 31st to convert to Roth. Realistically, you only have until about mid-December, since custodians are flooded with year-end requests and often cannot guarantee your conversion is processed if it is submitted after a certain date (December 10th, for example).

Converting your IRA to a Roth could save you or cost you thousands in extra taxes. You must calculate, or have your financial planner calculate, whether this is right for you. And then act.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.