6 Questions to Ask Before You Convert Your Traditional IRA to a Roth IRA

The decision to convert is not always clear

If you spend any time in financial forums or have read articles about IRA’s, inevitably you have seen some version of the phrase, “You can always convert your traditional IRA to a Roth IRA”.

Fundamentally this is true, however, the decision to convert funds in your traditional IRA to a Roth can be complex.

First, a quick overview of traditional versus Roth IRA’s. Both offer a break on taxes, the traditional IRA allowing you to avoid paying income tax on the funds you contribute up front, and the Roth allowing you to take distributions without paying income tax when certain requirements are met (most principal of which is being 59 ½).

The choice of which one is best to contribute to right now comes down to your effective tax rate. All else being equal, if your effective tax rate now is less than you will believe it will be when you want to take distributions, then you should contribute to a Roth IRA.

That is because the taxes you pay now on the money you contribute will be less than you would pay later. If the opposite scenario is true, you have a higher tax rate now than you believe you will at retirement, then a traditional IRA makes the most sense as you will defer paying income tax until the point where you will pay less in tax.

So, let’s say that like a lot of people in the middle of their earning years, you have a higher tax rate now than you believe you will later. A traditional IRA is the best retirement investment vehicle because you are avoiding paying the higher tax rate now.

Intuitively it makes sense that if you could then convert that traditional IRA to a Roth, then you would have the best of both worlds; reduced or no taxes on both ends of the transaction.

Unfortunately, it doesn’t work that way, so here are six questions to ask yourself before you consider converting your traditional IRA to a Roth:

1. How soon will you need the funds after you convert? There is a five-year holding period on funds that you convert to a Roth IRA. This means that you need to be 59 ½ AND the funds need to have been in the Roth for five years before you can withdraw them tax-free. Any funds withdrawn in the holding period (irrespective of whether you are over 59 ½) are subject to income tax.

2. Can you afford to pay the taxes on conversion? A traditional-to-Roth IRA conversion carries a tax consequence. You will have to claim the amount of conversion as income in the year you make the switch and pay tax at your effective rate for that year. Depending on your current income and the amount of the conversion, the move to convert may push you into a higher tax bracket for the year, further increasing the tax impact of the move.

3. Where will the funds to pay the conversion tax come from? Do you have cash on hand to pay the taxes on the conversion, or will you use funds from the conversion? A conversion of $200,000.00 will have a tax bill (in addition to your regular annual income tax) of nearly $40,000.00. If you use funds from the IRA to pay the tax bill, your nest egg shrinks from $200,000.00 to $160,000.00, significantly reducing the power of compounding that you would enjoy if you let the money stay put.

4. How much of my retirement income will come from investment accounts? If you are counting on your retirement investment accounts to entirely fund your lifestyle (aside from any social security income) then the consideration of whether to convert traditional IRA funds to a Roth is a worthwhile exercise. However, if you have a defined benefit pension, or will rely on rental incomes, working part time or any other sort of income stream to fund your retirement then the conversion consideration might be nearly irrelevant. In other words, any potential tax savings might be so miniscule as to not be worth the effort.

5. Are there other alternatives? Let’s say you are planning to convert your $200,000.00 traditional IRA account to a Roth, and you have the $40,000.00 you would pay in taxes on hand in cash. Is paying the tax bill the best alternative, or would leaving the IRA funds where they are and investing the $40,000.00 in a municipal bond index (with tax-free interest and earnings) be a better option?

6. How certain are you that your effective tax rate will be higher in the future? Essentially, conversion to a Roth only makes sense if the tax bill to do so now is less than you would incur to have the funds distributed from your traditional IRA in the future. If you are going to pay more now, it makes little sense to convert.

On the surface, the idea of converting your traditional IRA to a Roth IRA seems like it might be a slam dunk. Why wouldn’t you want tax-free income later?

The answer to that is that you wouldn’t want tax-free income later if it will cost you a lot more right now to get it.

Like most financial advice, generic recommendations for the masses are not always applicable to your own personal situation. The decision to convert your traditional IRA to a Roth depends a lot on your own individual financial picture and has a lot of moving parts and things to consider.

This article is meant to get you thinking about whether a Roth conversion might be right for you and pose a few questions to get you started. If you have answered the questions and believe the answers are pointing you to a Roth conversion, I urge you to consult your lawyer or financial advisor for more personalized advice.

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Timothy Key spent over 26 years in the fire service as a firefighter/paramedic and various fire chief management roles. He firmly believes that bad managers destroy more than companies, and good managers create a passion that is contagious. Compassion, grace and gratitude drive the world; or at least they should. Follow me on Instagram, Facebook, and Twitter, and join the mail list.