Roth IRA conversions are popular, and rightly so. The Roth IRA, with its unique tax advantages, can be a powerful financial-planning tool. However, rolling funds from a traditional IRA into a Roth is not the right move for everyone.
Here are five things to consider before making a Roth IRA conversion.
1. Your tax bracket, now and later
When traditional IRAs came into being, the idea was that your savings would be taxed once you were retired and in a lower tax bracket. However, these days it's not uncommon for retirees to be in a higher tax bracket during retirement. Luckily, most Americans now have the option of investing in a Roth IRA, which doesn't offer an up-front tax break but lets you withdraw funds in retirement tax-free. If you think you're likely to be in a higher tax bracket when you retire, then it might make sense for you to convert some or all of your retirement savings to a Roth before you retire.
More importantly, converting some or all of your traditional IRA money to a Roth IRA can provide a level of tax diversification in retirement to hedge against future changes in tax rates and related rules. Given the economic and political changes we see on a seemingly constant basis, this is an issue to be considered.
2. Estate planning
One of the benefits of a Roth IRA is that it isn't subject to required minimum distributions at age 70-1/2. Meanwhile, traditional IRAs require you to withdraw an IRS-mandated amount each year starting at that age, and every dollar is subject to income taxes.
Because Roth IRAs aren't subject to RMDs, they can continue to grow tax-free for as long as you live. If your beneficiary is your spouse, he or she can roll over the account and make the Roth IRA his or her own, and the same rules apply.
Non-spousal beneficiaries will be subject to an RMD, but that distribution won't be taxed. Moreover, if the rules are followed, non-spousal beneficiaries can take the RMDs over their entire life expectancy -- a great benefit for younger beneficiaries such as children or grandchildren. If they don't need the money, they can take the minimum distributions and allow the remaining funds to grow tax-free over a number of years.
3. Be ready for the tax hit
The main downside of a Roth IRA conversion is that any funds you roll over will be subject to income tax in the year of the conversion. Those who are older will need to think about whether they can cover that tax bill, or at least generate sufficient investment growth over a reasonable time frame to offset the impact.
The definition of "sufficient investment growth" and "reasonable time frame" will vary based on your unique situation. And there may also be other considerations such as estate planning that take precedent over "payback" concerns.
If you're willing to convert your traditional IRA to a Roth over the course of several years, then that's one way to avoid paying a disastrously huge tax bill in any given year.
4. College financial aid
If you have college-aged children who will be applying for financial aid, then it may be wise to avoid Roth conversions for the years that would affect their aid calculation: That extra taxable income could affect their eligibility for aid, or at least reduce the amount they're entitled to receive. It's generally better to work around those years to give your child the best shot possible.
If your child is within a couple of years of going to college, then you'd be wise to understand how the income for a Roth conversion is treated on the FAFSA, which is the online federal financial aid form widely used in determining your child's eligibility for financial aid and many scholarships.
5. Stock market declines
A drop in the stock market, as we've seen so far in 2016, can provide a great opportunity for a Roth IRA conversion. With the value of your IRA account depressed, you essentially get more bang for your buck, as you'll be converting a lower amount and thus paying less in taxes. If you're planning to roll over your traditional IRA, then consider taking advantage of the stock market correction by converting a larger portion of your old account. Think of it as another way of "buying low and selling high" -- the goal of every investor.
Converting your traditional IRA to a Roth IRA is a powerful tool that can provide financial planning options for many. Before doing a Roth conversion, however, make sure you carefully weight the pros and the cons -- and always keep the long term in mind.