7 Facts to Know About IRA Conversions

More than 70% of Ameri- cans are worried that higher taxes will be imposed on future distributions from traditional IRAs and 401(k)s, according to Allianz Life’s 2023 Quarterly Market Perceptions Study for the third quarter of 2023. That’s one reason a high percentage of participants in the same survey said they’re making effectively managing the taxes on retirement income a priority.

There are good reasons to be concerned about paying higher taxes on future retirement account distributions and to be looking now for ways to reduce those taxes. Traditional IRAs and 401(k)s have a lot of front-loaded tax breaks Congress created to encourage you to accumulate savings and investment returns in the accounts. Those tax benefits are only loans.

You pay the taxes when taking distributions from traditional retirement accounts. The distributions are taxable income. In addition, the IRA might have accumulated income that’s normally tax advantaged, such as long-term capital gains and qualified dividends.

But it’s all taxed as ordinary income when distributed, with taxes imposed at your highest rate. That’s essentially interest on the loan. Add the potential that income tax rates (or your tax bracket) could increase over time, and traditional IRAs and 401(k)s look more like tax traps than tax shelters.

You can minimize or avoid those future income taxes with some long-range planning that often involves repositioning your traditional retirement account. The most popular way to reposition your traditional account is to roll it over to a Roth IRA, also known as an IRA conversion.

While Roth conversions are the most popular way to reposition a traditional IRA, many taxpayers are wary of them. I believe widespread misinformation and misunderstandings about conversions keep more people from seriously considering IRA conversions. There’s a lot of conventional wisdom and many rules of thumb about conversions. Some of the thoughts are valid some of the time but don’t apply to everyone. Others simply never were accurate or oversimplify the situation.

Let’s correct some of these myths and develop facts. I’ll start with a rule of thumb most people assume is correct: Anyone in the top tax bracket shouldn’t consider an IRA conversion. In an IRA conversion, you roll over money from a traditional IRA or 401(k) to a Roth IRA. The converted amount is included in your gross income for the year, though it still is in an IRA. You pay the income taxes now in return for having tax-free distributions in the future.

It seems to make sense that you wouldn’t want to pay taxes at today’s highest rate when you could continue the tax deferral and pay taxes at the highest rate in the future. But you could pay a higher tax rate in the future, though you’re in the top bracket today. Today’s income tax rates are among the lowest in our lifetimes and even for most periods before that. More importantly, they could be the lowest rates for the rest of our lifetimes. The 2017 tax cuts are set to expire after 2025 if Congress doesn’t agree to prevent that.

Also, the federal government has significant debt, and annual budget deficits add to that debt. Though some disagree, at least some of the debt probably has to be reduced at some point. The increase in interest rates starting in 2021 adds to the debt burden by raising the amount of interest the government pays on new bonds.

Though someone might pay the top tax rate today, he or she could pay a higher rate in the future. The key issue isn’t the tax rate you pay today, it’s the probability you will pay a higher rate in the future. Another mistake is to focus only on income tax rates and overlook the Stealth Taxes that hit many middle- and upper-income retirees. Stealth Taxes include the tax on Social Security benefits, the Medicare premium surtax, the 3.8% net investment income tax and more.

Roth IRA distributions are excluded from income not only when computing regular income taxes but also when computing the Stealth Taxes. Future income taxes and Stealth Taxes can be avoided by converting all or part of traditional retirement accounts to Roth accounts.

Required minimum distributions (RMDs) are another oversight in many discussions of IRA conversions. Owners of traditional IRAs must take RMDs each year after turning 73, whether they need the money or not. The forced distributions can increase their income taxes and trigger or in- crease Stealth Taxes.

The RMD rules force owners to dis- tribute a higher percentage of their IRAs each year. The dollar amount distributed from the IRA could increase each year, triggering more and more taxes on income that isn’t needed. Retirees who didn’t anticipate RMDs often find that once they reach their late 70s, the extra taxes from RMDs become burdensome. A conversion of all or part of a traditional retirement account can avoid future RMDs, because the original owner of a Roth IRA doesn’t have to take RMDs.

Another piece of conventional wisdom about IRA conversions is that someone shouldn’t do a conversion unless there won’t be any distributions from the converted account for at least 10 years. Another form of this misconception is that it takes 10 years for a conversion to pay off. Some people crunch the numbers and find it would take about 10 years for the Roth IRA balance to equal what the traditional IRA balance was before the conversion. But that’s not the best way to look at the issue.

A conversion prepays taxes. The traditional IRA is really worth only the after-tax amount, not the amount on the account statement. I’ve done projections that show it takes about seven years for the Roth IRA balance to equal what would have been the after-tax value of the unconverted traditional IRA.

But even that isn’t the full picture because a lot of variables make up the projections. If tax rates increase soon after the conversion, the after-tax value of the traditional IRA declines. If the IRA earns a higher return than expected after the conversion, the benefits of the conversion increase. Perhaps a more important point is most of the comparisons assume the IRA is emptied in a lump sum at some point. Few people do that. Distributions are likely to be taken gradually over a long time, whether the IRA is converted or not. Gradual distributions from the IRA make a conversion more valuable over time unless your income tax rate declines. A related misunderstanding is that people older than a certain age shouldn’t do a conversion. But many older IRA owners have income and assets outside the IRA that are sufficient to fund their retirements.

Their traditional IRAs are held primarily for emergencies and to be left to their heirs. They don’t need a conversion to “pay off” during their lifetimes. An important consideration is that heirs will pay income taxes on distributions from inherited IRAs just as the original owners would have.

You’re passing a tax obligation to your children when they inherit a traditional IRA. They inherit only the after-tax value. In addition, because they probably are working and earning income, distributions from the inherited IRAs could push them into higher tax brackets and reduce the after-tax value of the inherited IRA. They might even be in higher tax brackets than yours.

Under the SECURE Act enacted in 2019, most beneficiaries of inherited IRAs are required to fully distribute those IRAs within 10 years, increasing the potential they’ll pay higher taxes. A better strategy for a traditional IRA that is intended for heirs is to convert it to a Roth IRA now or in stages over several years. You’re paying the income taxes for the heirs and ensuring they inherit a tax-free source of income.

Paying the conversion taxes doesn’t count as a gift under the tax code. It’s a way to make a tax-free gift to your loved ones. Plus, you still have the Roth IRA after the conversion, so it’s available in case of emergencies. Another misunderstanding is that people in the lowest, or one of the lowest, tax brackets shouldn’t consider conversions. Remember the key consideration is whether tax rates will be higher in the future. Even someone who’s in the lowest tax bracket today and doesn’t expect income to increase in the future could pay a higher tax rate in the future for the reasons listed earlier.

In that case, lifetime income taxes could be reduced by converting part of a traditional retirement account today. There’s another reason to consider a conversion even when the numbers and expectations don’t favor one or make it seem a break-even proposition.

Tax diversification has significant value in retirement because it gives you tax planning options and flexibility in the future that can reduce lifetime income taxes. Tax diversification is when you have assets in accounts that receive different tax treatments. There are taxable accounts, tax-deferred accounts (such as traditional IRAs) and tax-free accounts (such as Roth IRAs). We can try to guess what will happen to the tax law in coming years and establish probabilities for different outcomes.

But we don’t know. It’s risky to arrange our finances assuming there will be one future path for the tax code. When you have the different types of accounts, you have more control over your annual tax bills. When extra income is needed, you can decide from which account it makes the most sense to take the money. Another widespread rule of thumb is to wait until near the end of the year to consider converting a retirement account. This became popular advice after Congress eliminated the ability to reverse a conversion tax free. The thinking is that early in the year you can’t be sure what your tax picture will be for the year.

Your tax bracket and other factors might be different than what you expected at the start of the year. A conversion that made sense at the start of the year might make less sense late in the year. But not considering a conversion until late in the year could cause you to miss opportunities.

One of the best times to convert all or part of a retirement account is after a decline in the markets. Suddenly, you can convert 100 shares of a stock or mutual fund for a lower tax cost than you could have a few weeks or months earlier, to give one example. That opportunity might still be there near the end of the year.

But you don’t know. The markets could recover, and you missed a windfall opportunity to increase your after-tax wealth. IRA owners who must take RMDs need to know a key rule about conversions. In a year when you must take an RMD, the RMD has to be taken and included in gross income first. You can convert only from the post-RMD balance. That’s one reason it’s best to start considering conversions early in retirement or even in the pre-retirement years.

Another key point about conversions, especially for those in the retirement years, is the conversion might increase more than income taxes that year. If you are subject to the Stealth Taxes, the con- version will be included in gross income and could increase or trigger the Stealth Taxes. It doesn’t mean a conversion is a bad idea. It means you must consider the Stealth Taxes when estimating the tax cost of doing a conversion.