Is a Roth IRA Conversion Right for You?

February 11, 2022

Written by Dare Johnson, CPA Partner

Should I convert my retirement plan to a Roth IRA? It's an important question, particularly considering the Biden administration's intent to raise taxes on high-earning individuals. Given the often-sizable nest egg that people have accumulated during their careers, converting to a Roth IRA may be a smart move.

Roth vs. Traditional: What's the Difference? 

Taxes now or taxes later. Simply put, that is the main difference between a Roth and Traditional IRA. 

Contributions to a Roth IRA are made after-tax and withdrawals are tax-free. While Roth contributions can be withdrawn at any time tax-free, earnings from the Roth IRA cannot be withdrawn penalty free until age 59½ .  

Contributions to a traditional IRA are pre-tax and withdrawals are taxed as ordinary income. Individuals must wait until age 59½ to begin withdrawing funds penalty free and are required to start taking minimum distributions at age 72.   

A Roth IRA is often beneficial for individuals who expect to be in a higher tax bracket in the future. Those individuals can contribute now at a lower tax rate and avoid paying taxes at a higher rate in the future. Likewise, a traditional IRA is often beneficial if the individual will be in the same or lower tax bracket in the future.

For estate planning, a Roth IRA may have two significant benefits. First, a traditional IRA forces an individual to take minimum distributions and pay taxes on those distributions, even if they don't need the funds. A Roth IRA does not require minimum distributions. Second, a Roth IRA enables an individual's heirs to withdraw funds tax-free, whereas the beneficiaries of an inherited traditional IRA incur taxes on distributions. 

Cost of Conversion

When an individual converts a traditional IRA to a Roth IRA, the contributions and earnings in the traditional IRA account will be taxed as ordinary income. 

An individual must be aware that the income realized from the conversion could push them into a higher tax bracket for the year and thus must make those calculations.  

Fortunately, there are no penalties for Roth conversions, and account holders will avoid the 10% penalty for early retirement withdrawals.

Tax Rates and Considerations

Which will be higher: your tax burden now, during conversion, or your tax burden during retirement, when you take distributions? That's the million-dollar question. 

The Tax Cuts and Jobs Act reduced individual income tax rates from 2018 through 2025. Unless Congress enacts new legislation to reduce taxes, rates will increase in 2026. Furthermore, the Biden administration would like to pass legislation increasing both spending and taxes. Even though the Build Back Better bill did not pass the Senate, it doesn't mean that components of the bill won't be carved out into smaller pieces of legislation and passed.  

Regardless of how Congress affects future tax rates, an individual may experience a higher or lower future tax rate purely due to their future income level. An individual who is early in their career or a shareholder in a growing company may have higher earnings in the future and be pushed into a higher tax rate.  

Where someone plans to live out their golden years also matters. Federal laws apply across the board, but state laws vary in how they tax retirement income. In some states, required distributions from IRAs are not included in state taxable income. 

Future tax rates are important for those who plan on taking distributions during retirement. However, individuals who want to leave the funds for their heirs might benefit from a Roth IRA. Heirs are not taxed on Roth accounts and will also have several options for withdrawals.

As you can see, there are many things to consider when it comes to retirement planning and potentially converting your traditional IRA to a Roth IRA. This article only provides a high-level overview and is not a substitute for speaking with one of our expert advisors. Please get in touch with our office if you would like to discuss your specific situation and determine the best path for you and your family. We're always happy to help.