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What You Need to Know Before Converting to a Roth IRA

By Dan Caplinger – May 27, 2017 at 9:21AM

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Roth conversions can be smart, but you should know the facts first.

In the retirement savings world, traditional IRAs and 401(k) plans are far more popular than Roth-style IRAs and employer plan accounts. Yet most people have opportunities to convert traditional retirement assets to a Roth IRA. Doing so is often a smart move, but it's important to understand all the impacts of Roth conversions before you act. With that in mind, here's what you ought to know before converting your retirement assets to a Roth IRA.

1. Income limits on Roth conversions are history...

It used to be that if you had income of $100,000 or more, you weren't allowed to convert to a Roth IRA. However, those requirements went away beginning in 2010, and that opened the door for anyone to do a Roth conversion regardless of income.

2. ... but income is still a key factor in whether a Roth conversion is smart.

Just because you can convert to a Roth IRA doesn't mean that it's always a good idea. The most important thing to consider in your Roth conversion decision is whether your tax rate currently is higher or lower than what you expect it to be after you retire and start taking withdrawals from your retirement accounts. If your income is high, then you'll typically be in a high tax bracket. That means that when you pay tax on the amount that you convert to a Roth -- which typically must be included in taxable income in the year in which you do the conversion -- you'll pay a relatively high tax rate on it. If you expect to be in a lower tax bracket in retirement, then you might well have ended up with more retirement savings on an after-tax basis if you hadn't converted.

If, on the other hand, you're in a relatively low tax bracket now, then Roth conversions make more sense. By converting, you can essentially lock in that current low tax rate on your existing traditional IRA assets by getting the taxes out of the way now. Any future income and gains that the Roth IRA produces will be tax-free, potentially saving you a great deal in extra taxes -- especially if you anticipate that your success will put you in a higher tax bracket in retirement.

Roth sign.

Image source: Getty Images.

3. Roth IRAs give you more flexibility in retirement.

One advantage of Roth IRAs is that they don't force you to take required minimum distributions in retirement. Most holders of traditional IRAs and 401(k) accounts have to take certain minimum withdrawals once they reach age 70 1/2, and if they don't, they face an extremely harsh 50% penalty. So if you've managed your investment assets well and have multiple sources of potential income in retirement, you don't have to worry about the IRS requiring you to take money out of your Roth IRA against your will. That can make converting to a Roth look more favorable.

4. Consider your entire tax situation before converting.

Converting to a Roth will typically boost your taxable income for a given year, resulting in more tax. But in some cases, the increase in taxable income could have other implications unrelated to your retirement assets. For instance, if the rise in income puts you over the income thresholds for certain tax breaks, then you might miss out on favorable provisions you qualified for in the past. That isn't necessarily the best results.

Remember that you don't have to convert your entire traditional IRA balance to a Roth IRA. Converting just a portion works, and it might be appropriate if doing the whole thing would endanger valuable tax credits or deductions that would give you extensive savings on your tax bill.

5. You can change your mind about a Roth conversion.

The Roth recharacterization rules essentially give you the chance to undo your Roth conversion for whatever reason. So if your tax situation changes, the value of your IRA assets drops, or you just decide to change your mind about the whole Roth thing, then you have until the tax filing deadline for the tax year in which you made the conversion to get the assets back to where they were before the conversion. If you do so correctly, then there should be little or no tax impact.

Roth conversions are worth considering, but they also bring in some complicated issues. By being aware of those issues and incorporating them into your decision-making process, you'll be more likely to make the best choice possible for your financial situation.

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