Fisher Investments Reviews Roth IRA Conversions

In this article, Fisher Investments takes a closer look at the difference between Traditional and Roth IRAs, Roth IRA conversions, and what to consider before deciding whether a Roth conversion is right for you.

Understanding Traditional and Roth IRAs

Many investors have the option of contributing to a Traditional or Roth IRA, even if they have an employer-sponsored retirement plan such as a 401(k), 403(b) or 457(b). Traditional and Roth IRAs each have unique benefits and limitations, including contribution and tax deductibility limitations—the key difference between these two account types is when you pay income taxes. Below you’ll find out more about some of the key characteristics of Traditional and Roth IRAs.

Click each icon below to see some key characteristics for Traditional and Roth IRAs.

Differences Between Traditional and Roth IRAs

A Roth IRA is subject to the rules that apply to a Traditional IRA with the following differences:

What is a Roth IRA Conversion and Could It Be Right for You?

Roth IRA conversions transform Traditional IRA assets into Roth IRA assets. An investor can convert as much as they would like from a Traditional IRA into a Roth IRA, but the converted funds are subject to federal (and state, where applicable) income taxes. Depending on your income and the conversion amount, a Roth conversion could push you into a higher marginal federal income tax bracket.

The total taxable amount is affected by whether the underlying contributions to the IRA were deductible or not. Deductible contributions (and any gains on them) are taxed at their full current value—so if your Traditional IRA only has deductible contributions, you’ll pay tax on the full amount.

It’s often best to pay related income tax from an after-tax account, cash, or current income because using IRA funds to pay the tax reduces the amount converted into a Roth IRA dollar-for-dollar (and simultaneously increases your taxable income).

With a Roth IRA conversion, you are transforming fully taxable future income to tax-free income. By paying taxes up front, you won’t have to pay taxes when taking distributions in retirement. Consequently, Roth IRA conversions can potentially impact other resources such as Medicare and Social Security, so it’s best to review your situation with a trusted financial adviser and tax advisor to know what to expect before taking any action.

Since the main advantage of a Roth conversion is having tax-free withdrawals, it may benefit you if you expect to be in a higher marginal tax bracket in retirement. Additionally, you can time conversions to coincide with years when your tax bracket is lower—minimizing the amount of tax you may need to pay. Another benefit of a Roth conversion is heirs don’t have to pay taxes on the inherited Roth IRA and can keep the funds in the Roth for 10 years after your passing.

With few exceptions, most investors are eligible to convert Traditional IRA assets (cash or shares in-kind) into a Roth IRA. Importantly, you pay income taxes on the assets converted in the current tax year, rather than when you withdraw funds later in retirement (assuming you meet all Roth IRA five-year rules at the time of distribution). Ultimately, whether a Roth IRA conversion is right for you will depend on your specific circumstances, as will the conversion strategy that makes most sense.

When Might a Roth IRA Conversion Be Prudent?

A Roth IRA conversion may be part of a successful strategy if one or more of the following apply:

If you are viewing from a desktop, click on the icons below to see potential reasons why a Roth IRA conversion may be prudent.

These are the most common situations in which a Roth conversion can be attractive, but more nuanced and complex situations may arise.

Can You Withdraw Growth on Roth Contributions Tax-Free?

Yes, you can withdraw growth on Roth contributions tax-free so long as the following five-year aging periods are met:

• The Roth IRA owner is at least age 59.5 and at least five years have passed since the initial Roth IRA contributions were made.
• Each time a Roth conversion is completed, the conversion enters its own five-year period and applies solely to that portion of converted funds. There may be additional taxes associated with earnings withdrawn from the Roth IRA prior to the end of this new five-year period. Keep that in mind if you are deciding whether to complete a Roth conversion, the earnings would be taxable for a minimum of five years.^[vi]
• Of course, you can always forgo the wait, and take out contributions and converted funds. However, if you are under age 59.5, you may be subject to a 10% penalty for withdrawing converted funds prior to meeting the five-year rule on that conversion.

Can Roth IRA Conversions be Reversed (‘Recharacterized’) Once Completed?

No—the Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the recharacterization of Roth IRA conversions made in 2018 or later. Prior to the law’s enactment, investors had the ability to recharacterize (undo) a Roth IRA conversion up until October 15th of the year following the year the conversion was made. For all new Roth IRA conversions, it’s incredibly important to understand you cannot reverse the action and must plan for the resulting tax bill. This makes the due diligence before completing a Roth IRA conversion even more important.

Your Situation Determines Whether a Roth IRA Conversion is Best for You

At the end of the day, whether a Roth IRA conversion is right for you depends on your personal circumstances. A Roth IRA conversion can be attractive and financially prudent, but the decision may be more nuanced depending on the complexity of your financial situation. In our view, you should start the discussion about whether a Roth IRA conversion makes sense with your financial adviser and tax advisor to review the details of your personal financial situation, including long-term goals, tax obligations and possible impact to your estate plans.

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Additional Resources

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