The right time for a Roth IRA conversion?

By: Kimberly Lankford

There’s a silver lining to this year’s market downturn: It can be less expensive to convert money from a traditional IRA to a Roth. You have to pay taxes on the conversion, but the tax bill can be lower when the value of your investments is down. It can also be a good time to convert because tax rates are still low, too — and yours may be even lower this year if your income is also down.

Converting money from a traditional IRA to a Roth can be a smart financial-planning move: After you pay taxes on the conversion, the money will grow tax-free in the Roth IRA for the future. Having money in a Roth IRA can help help diversify your tax situation — you’ll be able to tap the account tax-free in retirement, which can be particularly helpful if most of your retirement savings is in tax-deferred 401(k)s, traditional IRAs or a taxable pension. Your heirs can inherit a Roth IRA tax-free. And you’ll never have to take required minimum distributions from the Roth IRA, so you can leave more money growing tax-free in the account at any age. There are no income limits for making Roth conversions, even if you earn too much to make Roth IRA contributions.

Now can be a good time to convert some money from a traditional IRA to a Roth, and special rules make it even better this year. But you need to be careful to avoid some unintended consequences. Here’s what you need to know:

Understand how taxes are calculated on the conversion. You have to pay income taxes on the conversion, and the taxable amount depends on where your IRA money came from. If all of your money in traditional IRAs came from pre-tax or tax-deductible contributions, then the full amount you convert will be subject to income taxes. But if some of the money was from nondeductible contributions, then part of the conversion will be tax-free (because that money had already been taxed) and the rest of the conversion is taxable.

To figure out what portion of the conversion is tax-free, add up the nondeductible contributions you made through the years and divide it by the total balance in all of your traditional IRAs. For example, if you made $10,000 in nondeductible contributions and the total balance in all of your traditional IRAs is $100,000, then 10% of your conversion will be tax-free and 90% will be taxable — no matter how much money you convert.

You usually have to take your RMD before you convert, but not this year. If you’re 72 or older, you usually have to take required minimum distributions from your traditional IRAs and 401(k)s (and pay taxes on the withdrawals) before you can convert money to a Roth. But the CARES Act, which Congress passed to provide coronavirus financial relief, waived the RMD requirement for 2020.

Since you don’t have to take the money out of the account this year, this could be a good opportunity to take at least the amount you would have had to withdraw and convert it to a Roth IRA instead, so it can grow tax-free for the future.

Be careful of unintended consequences from the conversion. Money you convert from a traditional IRA to a Roth increases your adjusted gross income, which could bump you into a higher tax bracket or lead to other extra costs.

For example, the additional income from the Roth conversion could make you subject to the Medicare high-income surcharge. Most people pay $144.60 per month in 2020 for Medicare Part B, which covers doctors’ fees and outpatient services. But if you’re single and your modified adjusted gross income is more than $87,000, or more than $174,000 if you’re married filing jointly, then you have to pay $202.40 to $491.60 per month, depending on your income. Your Medicare Part B premiums are generally based on your last income-tax return on file, so a conversion in 2020 could boost your premiums for 2022. You may be able to contest the high-income surcharge if you’ve experienced certain life-changing events since then, such as retirement, divorce or death of a spouse (see https://www.ssa.gov/forms/ssa-44-ext.pdf Form SSA-44 at SocialSecurity.gov). But you can’t contest the surcharge just because your income was unusually high that year. However, if your income drops down the next year, your Medicare premiums will drop the following year, too.

You may want to spread out your conversions over several years to make sure you fall below the income cut-off.

There’s no do-over for conversions, as there had been in the past. Before 2018, your Roth conversion didn’t have to be permanent — you had until October 15 of the year after you converted the money to undo the conversion, a process called “recharacterization.” That way, you could convert the money to the Roth, but then you would still have plenty of time to reassess the decision if your situation changed — if, for example, you realized you may not be able to afford the tax bill on the conversion. Some people would recharacterize if their investments continued to lose value after the conversion — they could undo the conversion and reconvert later at the lower value, reducing their tax bill on the conversion.

But the tax laws changed, and the ability to recharacterize a Roth conversion went away in 2018. Now, you need to be more careful when you do the conversion because you can’t change your mind later.

Keep track of the five-year holding period. You can withdraw money you contributed directly to a Roth IRA tax-free and penalty-free at any time. You can withdraw earnings from a Roth IRA tax-free if you’re over age 59 ½ and have had a Roth IRA for at least five years. But the rules get a bit more complicated if you’ve converted money from a traditional IRA to a Roth. Money you converted to a Roth isn’t taxable when withdrawn because you already paid taxes on the conversion. But you may have to pay a 10% early-withdrawal penalty on that money if you’re under age 59 ½ and less than five years have passed since the conversion. Each conversion has a separate five-year holding period. The clock starts ticking on January 1 of the year you make the conversion, regardless of the month you convert.

But this rule may not affect you, depending on how much money you withdraw. When you withdraw money from a Roth IRA, the IRS considers the first withdrawals to come from your contributions, which are tax-free and penalty-free at any time. After you withdraw your contributions, the IRS considers the next withdrawals to be from converted amounts, with the oldest conversions withdrawn first. This portion of the withdrawal is tax-free and will be penalty-free if you’re over 59 ½. You’ll only have to pay a 10% early-withdrawal penalty if you’re under 59 ½ and less than five years have passed since you converted the money. Then the last withdrawals are considered to be from earnings, which are tax-free and penalty-free if you’re over 59 ½ and have had a Roth IRA for at least five years (based on the date of you first established a Roth IRA, which is different from the date of any conversions).

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