WHY CONVERT a traditional IRA to a Roth IRA? The rationale is similar to the reasons you might funnel your regular annual contributions into a Roth rather than a traditional IRA. There are, however, four additional considerations.
First, you might convert to a Roth if you have a year with low taxable income, so you pay tax on the conversion at a relatively modest rate. Remember, when you convert, you have to pay income taxes on the taxable sum converted.
That brings us to the second reason you might convert: Suppose that, in the past, you hadn’t been eligible to fund either a tax-deductible IRA or a Roth IRA, so you ended up making nondeductible contributions to your traditional IRA. When you convert, you don’t have to pay taxes on those nondeductible contributions. In fact, some high income earners regularly fund nondeductible IRAs and then convert them to a Roth, a strategy known as the “backdoor Roth IRA.” But be warned: For tax purposes, you can’t pick which IRA to convert. Instead, you have to assume that the money comes proportionally from all your IRAs combined—which might mean a larger tax bill than you had hoped. There’s more on that in the next section.
Third, you should convert only if you have money in a regular taxable account to pay the tax bill triggered by the conversion. Using this taxable account money to pay the conversion tax should, thereafter, lower your annual tax bill. How so? Not only will your IRA withdrawals no longer be taxable, but also you’ll shrink the size of your taxable account, so that account no longer generates as big a tax bill. Think of it this way: By converting to a Roth and paying the tax bill with taxable account money, you effectively move money from your taxable account—where it’s getting taxed each year—to a Roth, where it can grow tax-free.
Finally, you might convert if we have a stretch of bad market performance. Your traditional IRA will be shrunken, and hence so too will the tax bill due upon conversion. An added bonus: If the market later rebounds, and the investments in your new Roth IRA go along for the ride, all the gains will be tax-free.
A frequent question asked by those age 72 and older: Can you convert a traditional IRA to a Roth—and count the conversion toward that year’s required minimum distribution? The answer, alas, is no. We discuss required minimum distributions in more detail later in this chapter.
Our Humble Opinion: We’re huge fans of Roth accounts. If you have a year with relatively little taxable income, consider converting a portion of your traditional IRA to a Roth. In retirement, you might tap your Roth if you have a year with high expenses and you don’t want to pull money from traditional retirement accounts, which could nudge you into a higher tax bracket. Better still, try not to spend your Roth—and instead bequeath it to your favorite relative.
Next: Backdoor Roth
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