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A Roth conversion refers to the process of converting assets from a tax-deferred, or pre-tax, retirement account into a Roth, or after-tax, retirement account. The main benefit of a Roth conversion is that it allows you to establish a source of tax-exempt retirement income, which can give you greater flexibility to create a tax-efficient retirement income stream. Once the assets are held within the Roth account, they are free to grow and compound on a tax-exempt basis, and unlike tax-deferred retirement assets, Roth after-tax assets are not subject to required minimum distributions (RMDs) in retirement.

However, a Roth conversion itself can lead to significant tax consequences because any amount converted from a pre-tax account to an after-tax account is taxed as ordinary income during the year in which the conversion takes place. This makes it important to carefully plan the timing of your Roth conversion. The following considerations can help you get the timing right.

Consideration #1 – The nuances of a Roth conversion

A Roth IRA conversion, sometimes called a backdoor Roth strategy, is a way to participate in a Roth IRA when your income exceeds the standard eligibility limits. The converted amount is treated as taxable income and may affect your tax bracket, increasing your federal, state and local tax exposure. If you are subject to an RMD in the year of conversion, the RMD must be completed before the conversion can take place.

To qualify for tax-free withdrawals, you must generally be age 59½ and have held the converted funds in the Roth IRA for at least five years. Each conversion has its own five-year minimum period, and early withdrawals may be subject to a 10% early withdrawal penalty unless an exception applies. Income limits still apply for future direct Roth IRA contributions.

Consideration #2 – Your anticipated annual income

The amount you convert from a tax-deferred account, such as a 401(k) or traditional IRA, to a Roth account is taxable as ordinary income during the year in which the conversion takes place. If this amount bumps you up into a higher tax bracket, you may face higher taxes than anticipated.

The best timing for a Roth conversion is during a year in which your income is less than normal. For example, maybe you took some time away from work or made a sizable charitable donation that reduced your income enough that you fall into a lower-than-normal tax bracket. This could be a great time for a Roth conversion.

Consideration #3 – Current market conditions

It may make sense to initiate a Roth conversion during a year in which your portfolio value drops. If you sell assets from a tax-deferred retirement account when the value dips, you will likely pay taxes on fewer assets. As long as you have enough time to recover, you can reinvest those assets in a Roth IRA and position them for future growth and tax-exempt appreciation.

For example, let’s say the value of your traditional IRA was $150,000 at the beginning of the year. Due to market volatility, the value has dropped to $100,000. If you initiate a Roth conversion on the lower asset value, you will owe taxes on $100,000 instead of $150,000. If you then reinvest the $100,000 in your Roth IRA, you can position the assets for a future market recovery.

Keep in mind that correctly timing the market is incredibly difficult, and there are other important factors that should be taken into consideration. Be sure to consult with an experienced wealth manager before taking action.

Consideration #4 – Your investment time horizon

The longer your assets are invested in a Roth account, the more effective your conversion will be. That’s because you need to give your assets enough time to grow tax-free in order to overcome the tax liabilities of the conversion itself. For example, if you are within just a few years of retirement, you may not have enough time to grow your Roth assets enough to make up for the tax liability of completing the conversion.

Your wealth manager can run various projections to help you determine whether a Roth conversion makes sense, based on your investment time horizon, potential tax exposure and future goals.

Consideration #5 – Your legacy goals

If your goals include passing along a sizable inheritance to your loved ones, there are two main estate planning benefits to completing a Roth conversion.

1. Tax-exempt distributions to your heirs – Withdrawals from Roth IRAs are generally exempt from federal income taxes, which can lead to tax savings for your heirs.
2. A longer time horizon for growth – Because Roth assets are not subject to RMDs, they are able to remain invested for a longer period of time. This provides an opportunity for enhanced growth and asset accumulation.

When NOT to complete a Roth conversion

Typically, it does not make sense to complete a Roth conversion in the following situations.

• You expect to fall into a lower tax bracket in the future.
• The conversion will bump you up into a higher tax bracket for the year.
• You are experiencing a year with high taxable investment gains.
• You will need access to the money within five years (example, as a withdrawal in retirement), as there is a five-year waiting period to withdraw Roth IRA funds without a penalty.
• You plan to bequeath your IRA to a charity after you die. (It’s generally better to make a tax-free charitable donation of appreciated securities.)
• You do not have enough cash on hand to pay the additional taxes that result from the conversion.
• You recently experienced an event that resulted in a large lump-sum payout, such as a business sale, significant bonus, deferred compensation payout, etc.
• You are 65 or older and collecting Medicare. In this situation, the Roth conversion may push you into a higher tax bracket, which could result in higher monthly premiums.

If you are considering a Roth conversion, it’s important to work with a qualified wealth manager who can help you weigh the pros and cons in relation to your specific financial situation, tax exposure, investment time horizon, risk tolerance and more.

At North Oaks Wealth Management, we support clients in building strong financial futures, one brick at a time. If you could use some help determining whether a Roth conversion makes sense for you, we would love to have a conversation. Please schedule a call to learn more.