The Skinny on Roth Conversions

There is an ongoing interest in the idea of doing an IRA Roth conversion. Let me try to put the paramount issues in perspective. We will deal here with the pros, the cons and the variables—sort of like the good, the bad and the ugly (apologies to Clint Eastwood).

First, the good. As you all probably know, subject to certain technicalities, whatever you take out of a Roth is tax free. Also, it retains that status in your estate. Roth accounts are not subject to RMD requirements for distribution, other than when they are inherited.  Even then, the RMD issue is not a severe one, and the distributions are tax free.

Now, some of the inevitable not so good. The biggie that pretty much everyone is aware of is that when you move money from an IRA converting it into a Roth IRA, whatever you remove from the IRA is taxable at the time you remove it.  Depending on the magnitude of the funds involved, this can create a significant tax burden. You pay the tax now, for the benefit of paying no tax years down the road when the money is removed from the Roth. Another negative which is not always recognized instinctively, is that if you already are receiving Medicare, there is a good chance that in the year you do a Roth conversion, your income will increase, perhaps significantly, perhaps enough to make a difference in the IRMAA surcharge assessment on your Medicare insurance. That needs to be considered as a potential negative factor. The good news on that issue is that the IRMAA is impacted only in the year of the conversion, and does not create a carryover ripple effect.

Then of course there are issues that are neither automatically good or bad. Your tax bracket now compared to what you think your tax bracket might be years down the road (in retirement?) can be a very big factor.  You will be paying tax on the conversion based on your current tax bracket, at a rate that will also for the moment include the magnitude of the Roth conversion. If, as an example, you are currently working, you may find that the tax bracket for making a current Roth conversion is rather onerous.  If you convert when you are in a high bracket, and then have the distributions down the road when you are in a low tax bracket, you have probably lost money. People sometimes get carried away with the idea of reducing their ultimate taxable IRA RMD to avoid tax years from now—but lose sight of the possibility (for many, the probability) your tax bracket in retirement or years from now may not be all that high, and thus it can be very costly to do a Roth conversion at the present time.

The other kind of variable issue is age. The younger you are when you do the conversion, the better. That is because the younger you are likely there'll be more years forward to have the Roth funds generating tax free income. Thus, ignoring for the moment the discussion immediately above about tax brackets, arguably doing a Roth conversion at age 30 or 40 might be called a no brainer; whereas doing a conversion at age 70 or 80 requires much greater consideration because you'll be paying tax now and you will not in all likelihood have that many more years to regain the tax cost via earnings tax free in the Roth.

What it comes down to is that while there are some standard guidelines as to the logic of making a conversion, it is a very personal decision and needs to be considered in the light of your personal financial and tax situation.