Is this the year you finally convert to a Roth IRA? It could be if it makes sense for your situation, but there are numerous factors that come into play. Do not make any rash decisions.
Basic premise: Generally, distributions from a traditional IRA are fully taxable at ordinary income rates reaching as high as 37%. Also, traditional IRA payouts may trigger or increase the 3.8% net investment income tax (NIIT) due to the way it is calculated. In contrast, qualified distributions from a Roth IRA in existence at least five years—including those made after age 59½—are completely exempt from tax. Other Roth distributions may be wholly or partially tax-free under special “ordering rules.”
However, a Roth conversion is currently taxable and that is often the problem. Here are several questions you should answer before you convert.
Can I afford the current tax?
Determine if you will have to tap into your retirement funds to pay the conversion tax. This will erode your nest egg and could actually hurt more than a conversion will help. The more money you convert and the higher your tax bracket, the bigger the tax hit.
What is your expected tax rate in retirement?
If you anticipate being in a significantly lower tax bracket when you receive payouts than you are in now, it may be easier to absorb tax on those future distributions than it is to pay a conversion tax this year. Conversely, if you expect to be in a higher or the same tax bracket in retirement, a current conversion may be suitable, absent extenuating circumstances. To complicate matters, tax rates could change in the future.
Note that you may be able to reduce the tax fall-out by making a series of conversions over the course of time.
What are other expected sources of income in retirement?
If the bulk of your assets needed for retirement have been salted away in vehicles like growth stock and a 401(k) account, a Roth conversion may provide the flexibility you will need later in life. It may help meet your lifestyle or estate planning objectives without triggering tax on every withdrawal. Because you do not know how the tax structure might change over time, it may also be a good idea to build some tax diversification into your accounts.
How do you plan to pass retirement assets to your heirs?
With a traditional IRA, you must begin taking required minimum distributions (RMDs) for each tax year, beginning by April 1 of the year following the year you turn age 72 (recently increased from age 70½). For each subsequent tax year, the RMD must be taken by December 31 of that year. But there are no mandatory lifetime distributions with a Roth, giving it an edge for those who want to preserve more funds for their heirs.
This is just the tip of the iceberg. There are other considerations that go into the decision to convert to a Roth IRA or not. Practical advice: Analyze your personal situation with assistance from your professional tax and financial advisors.
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