Roth Conversion Considerations

By Erica Eros | Qualified Plans

Converting a Traditional IRA or employer-sponsored retirement account to a Roth IRA may offer more flexibility at retirement for the Roth IRA owner. Roth IRAs have no required minimum distributions, and post death distributions to beneficiaries are tax-free. Because tax rates are historically low, it may be a good time to consider a Roth IRA conversion.

  • Doing one large conversion may push the taxpayer into a higher tax bracket but doing partial conversions will allow for the tax payments to be spread out over several years.
  • Use non-IRA funds to pay for income tax on conversion.
  • There is no income limit on eligibility for converting a Traditional IRA to a Roth IRA.
  • When doing a Roth conversion of any nondeductible retirement account, you must consider what the client has in any pre-tax traditional, SEP, or SIMPLE IRA accounts. Any pre-tax balances in these accounts would require the use of Pro Rata Rules on the conversion.
  • Married tax filers have the most favorable tax bracket. Couples should consider a Roth conversion before the first spouse’s death.
  • Upon conversion, pre-tax contributions are taxed as ordinary income and after-tax contributions are not taxed. The pro-rata formula is used to determine how much of a conversion is taxable when the account holds both pre-tax and after-tax contributions. The rule combines all SEP, SIMPLE and Traditional IRAs as if they are one.
  • The pro-rata share (tax-free portion) is calculated starting with the sum of all after-tax dollars in all Traditional IRAs. Divide the sum of after-tax dollars by the 12/31 balance of all Traditional IRAs. Then multiply that percentage by all Traditional IRA distributions. The following example illustrates the pro-rata calculation:

    If you have $20,000 of after-tax dollars in all your IRAs and the total balance of all your IRAs is $100,000, your percentage of after-tax dollars is 20% ($20,000/$100,000 = 20%). If a distribution of $10,000 were made, the tax-free portion would be $2,000 (20% x $10,000 = $2,000). The remaining portion of the distribution ($8,000) would be taxable at ordinary rates.

While there are many benefits of doing a Roth conversion, there are also situations where a conversion may not make sense:

  • Does the IRA owner need the IRA funds to meet annual living expenses? A five-year holding period applies to earnings in the account.
  • Will the conversion push the IRA owner into a higher tax bracket? Calculate the Alternative Minimum Tax (AMT) implications of the conversion.
  • Will the client die with a substantial charitable bequest?
  • The Tax Cuts and Jobs Act passed in December 2017 eliminated the ability to recharacterize or undo a Roth conversion.

It is always a best practice to have the client’s tax professional run the numbers to verify any tax consequences of a Roth conversion and the optimum conversion amount.

If you have any questions, contact us in Case Planning – Qualified Plans by email at QPinfo@bdops.com.

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