You’ve probably heard of the possibility of converting traditional IRAs to Roth IRAs. Since these are two quite different financial instruments, whether this is a good decision depends on your particular situation, your goals and the timing.
Whether you can contribute to a Roth, after you convert to one, depends on your current and projected income. For low-income healthcare professionals, these conversions may be more feasible and beneficial than for physicians. Yet, if they use the right strategy, physicians can also benefit significantly.
The main appeal of converting to Roth is that because these accounts are funded with after-tax dollars (income already taxed), distributions are not taxable on income withdrawals, but only if certain conditions are met (including a five-year waiting period). In contrast, every pre-tax penny withdrawn from a traditional IRA—both contributions and investment gains—is taxed at your ordinary income tax rate.
IRS rules require traditional IRA holders to begin gradually withdrawing money in the form of Required Minimum Distributions (RMDs) starting at age 72 to reduce and eventually deplete these tax-deferred accounts. And after the start of the RMDs, no further contributions are allowed. On the other hand, RMDs do not apply to Roth IRAs, and you can contribute to these accounts as long as you have earned income, i.e. wages, salaries, fees or commissions. receipts for the work you do.
Due to a relatively recent change in tax rules, Roth conversions are now irreversible, as are their tax consequences. It is therefore more important than ever to understand the impact of a Roth conversion.
While conversions can provide distinct benefits, they can also lead to unintended consequences that can be very disadvantageous. Understanding these impacts is key to making an informed decision about converting from a traditional IRA to a Roth. Financial planners and popular articles on the subject tend to tout the benefits of Roth IRAs without exploring the downsides of Roth conversions. The mechanisms of conversion strategies, based on the particular circumstances of individuals, are also underestimated.
Here are some things to consider when considering taking this step:
- For Roths earnings withdrawals to be tax-free, as noted above, five tax years must have passed since the account was created, either by making an initial contribution or by converting a traditional IRA . Additionally, there is a 10% penalty for those under 59.5, although there are some exceptions.
- Roth conversions typically involve tax pains, meaning any amount from a traditional IRA you convert is treated as income in that tax year. To minimize the tax impact, it’s usually best to convert to a low-income year or a year where you have high deductions reducing your taxable income, such as uninsured medical expenses.
- Some conversion strategies focus on spreading the tax pain over time. If there is a period of low-income years ahead, you may want to start converting then, and do so gradually, a tranche of IRA assets per year. When using this strategy, it is important to remember that each bracket has its own five-year clock for eligibility to withdraw tax-free winnings. So, when withdrawing winnings, it is essential to know which installment you have converted and in which period so that you do not inadvertently incur a large tax bill.
- Managing your tax brackets is essential. To get the most out of the tax you incur with each converted IRA bracket, it’s essential to take full advantage of each tax bracket. For example, if converting $30,000 of assets would increase you two or three tax brackets but $10,000 would keep you in your current bracket, then maybe $10,000 is all you would want to convert this year. But if you can convert $20,000 and stay in the same bracket – or the next one, if it’s not too harsh – you might want to convert $20,000 that year. Financial planners call this practice filling in your parentheses.
- Even if you spread your conversion over several years and manage your tranches strategically, it may take more than a decade for the benefits of conversion (non-taxable investment gains) to accrue to the point where they do. outweigh the tax costs involved. It is therefore important to take into account your state of health and your age to estimate if you would gain a net benefit from the conversion.
- IRS rules prohibit Roth contributions from people with annual incomes of $144,000 and more, and for married couples jointly filing $214,000 and more. That’s why financially savvy doctors sometimes set up a Roth and contribute to it early in their careers, while they’re still below that ceiling. Later in their careers, this income cap prohibits most physicians from contributing. However. they may be able to convert in the tax year following the year of their retirement or after they begin to reduce their practices – if early retirement has lowered their earnings below the ceiling.
In this situation, a viable strategy might be to convert the year after retirement, while delaying the onset of retirement income streams, such as Social Security (which must be applied for before age 70) and pensions until the year following the end of the conversions. So even the highest-earning doctors could not only qualify for a Roth, but could also reach a much lower tax bracket in the first year of a conversion process and keep their tax bracket low all the time. by converting the following slices. For high earners, this period between retirement and the start of retirement income streams is sometimes called the golden zone for Roth conversions.
- Physicians and other high-income individuals whose income level disqualifies them for Roth IRAs may be able to convert their 401(k) accounts to a Roth IRA while they are still working by performing a backdoor conversion, assuming as the rules of their employer’s 401(k) plan permit. . This potentially highly tax-efficient method of conversion involves complicated but entirely legal maneuvers that allow high earners to circumvent income limits on Roth contributions.
- To avoid compounding the tax impact of a traditional IRA to Roth conversion, it is not advisable to pay this tax with IRA money. This defeats the purpose, because the goal is to get as much of the value of your IRA as possible into a Roth to protect future gains from taxes. It is usually best to withdraw funds to pay taxes from a non-qualified account.
- An IRA to Roth conversion for estate planning purposes is often a good idea for high earners, such as doctors. The lifetime federal gift and estate tax exemption is currently $12.06 million per person in 2022 (for married couples filing jointly, double that amount). Estates below this size are not subject to inheritance tax for heirs. This exemption is expected to drop to $5 million (adjusted for inflation) by the end of 2025, but it could be extended, or a significantly higher exemption could be set before then.
If the value of your estate is close to this limit, it may be advisable to have a Roth conversion, as paying taxes would reduce the size of your estate, possibly helping to keep it below the exemption amount and saving thus to your heirs the burden of inheritance tax.
Additionally, inheriting a Roth instead of a traditional IRA provides other significant tax benefits to heirs, especially surviving spouses. By becoming the account holder through what is known as a spousal transfer, spouses become subject to the rules applicable to new accounts: earnings cannot be withdrawn tax-free for five years, and account holders must be at least 59 ½ years old to avoid a tax penalty on these withdrawals. . But after that, the account is treated as theirs originally. There is no RMD and they can keep the account for life and leave it to their heirs. These heirs have 10 years to distribute all the assets in the account, to liquidate them and withdraw all the money, tax-free.
This is also required of non-spouse heirs who inherit your Roth. Beneficiaries who receive traditional IRAs also have 10 years to distribute the assets, but they must pay taxes on those distributions. For those inheriting a large IRA, the 10-year limit can mean a decade of much higher tax brackets.
To give these benefits to your joint and non-joint heirs, you’ll probably have to wait until your retirement to convert, assuming that’s feasible based on your earned income.
- If the value of your estate is well below the exemption amount and you plan to leave your traditional IRA to an heir, converting it to Roth first may or may not be a good idea. Paying the tax would mean less leaving your heir. But if your Roths beneficiary is your spouse, it might be worth paying the conversion tax for you because of Roths’ significant tax benefits for spouses. This is especially true when you inherit accounts that have grown significantly over time.
If the heir is your adult child and you leave them a traditional IRA instead of a Roth, the taxes on the distributions can be much lower than yours depending on the child’s tax bracket.
- If you have Medicare in the year you convert from a traditional IRA to a Roth, you should be aware that the resulting ordinary income jump can increase your monthly Medicare premiums, possibly significantly. These increases would begin in January of the calendar year following conversion and continue throughout the year. So it’s a good idea to include this factor in your cost versus benefit calculations. Of course, this affects low-income people more than high-income people, such as doctors.
By fully understanding the impacts of a Roth IRA conversion on your current and projected financial situation, you can make an informed decision about whether to take this step and, if so, how and when.
David Robinson, a CERTIFIED FINANCIAL PLANNER™ Professional, is a Principal and Senior Wealth Advisor at Mariner Wealth Advisors in the firm’s Phoenix office. He provides wealth planning services and creates personalized financial plans to help clients grow and protect their wealth, manage taxes and identify insurance solutions. He also prepares clients for retirement and manages estate plans. Prior to joining Mariner Wealth Advisors, he was CEO of Robinson, Tigue and Sponcil, an SEC-registered advisory firm in Phoenix.