Roth IRAs are a popular retirement savings and investment tool, especially for those expecting to be in a higher tax bracket in retirement, because of their tax advantages. However, a Roth conversion also comes with immediate tax consequences that require careful planning.
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Here are four tax rules to understand before you convert your IRA to a Roth account to avoid costly surprises and maximize benefits.
In simple terms, converting an IRA to a Roth account means moving money from a traditional IRA or another pre-tax retirement account into a Roth IRA. It makes all pre-tax contributions and earnings taxable during the year of the conversion. Future, qualified withdrawals from the Roth IRA are tax-free.
“A conversion is beneficial if you expect to be in a higher tax bracket in retirement,” said Ines Zemelman, an IRS-authorized enrolled agent and founder and president of TFX, a tax advisory firm. “If you are planning to retire abroad, consider cross-border tax implications.”
Zemelman recommended spreading the conversions across multiple years to avoid higher tax brackets while minimizing tax liability. The ideal time for a Roth conversion is during the early retirement years, before Required Minimum Distributions (RMDs) or Social Security begin.
“It’s beneficial for legacy planning, as Roth IRAs pass tax-free to heirs,” Zemelman said. “Converting funds before retiring abroad can avoid unfavorable or double-taxation in some countries.”
In addition, many employers offer in-plan Roth conversions, said Elizabeth Schleifer, a financial advisor at Armstrong, Fleming & Moore, Inc.
“Employees can transfer money from their traditional (pre-tax) 401(k) to a Roth 401(k) in the same plan,” Schleifer said. “Employees pay taxes on the converted amount. So, it makes sense to do this if you have an have an unusually low-income year, either due to a large deductible expense or a drop in income.”
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A Roth conversion increases your adjusted gross income (AGI) for the year, which can affect several areas of your financial life.
“A higher AGI may lead to increased Medicare premiums under IRMAA (Income-related Monthly Adjusted Amount), taxation of a larger portion of your Social Security benefits or reduced eligibility for tax credits like the Child Tax Credit or the Saver’s Credit,” said Arron Bennett, founder and CEO of Bennett Financial. “These considerations should be part of an overall financial plan to ensure the conversion aligns with your broader goals.”
Bennett said that incorporating other investments, such as in the oil and gas sectors, can help mitigate the tax impact of the conversion and reduce its effect on other financial areas.
“For example, a current oil and gas investment conversion allows for 60 cents on the dollar in tax mitigation, meaning you’re only taxed on 40% of the amount being rolled into the Roth IRA,” Bennett said. “Typically, tax mitigation for these types of conversions is around 42 cents on the dollar. Once converted, the funds grow tax-free, and if specific conditions are met, withdrawals in retirement are also tax-free.”
State income taxes are often applicable for Roth conversions, depending on where you live. For example, Bennett said Florida and Texas don’t impose state income taxes, while California or New York can impose significant state income taxes on conversions.
“It’s crucial to understand your state’s tax policies and factor them into your planning,” Bennett said. “If you’re planning to relocate to a no-tax state, consider postponing the conversion until after the move to maximize savings.”
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This article originally appeared on GOBankingRates.com: 4 Tax Rules To Understand Before You Convert Your IRA to a Roth Account
