After years of historic gains, financial markets have been thrown into uncertainty, in a large part due to the COVID-19 pandemic. The recent bull market, combined with the rise in popularity of more passive investment tools such as index funds, may have caused some people to take a hands-off approach to their investments. But with current conditions, it’s important to stay on top of your finances and take certain measures to protect your retirement for the long-term.

One step you could take to do this is by converting your traditional IRA to a Roth IRA. This proactive approach is particularly useful when asset values and tax rates are low (such as now). Here are a few things you should consider before converting your traditional IRA to a Roth.

Traditional Vs. Roth

Before diving into why you may want to convert your IRA, let’s quickly review the key differences between traditional IRAs and Roth IRAs.

Traditional IRAs

Contributions to this type of account may be wholly or partially tax-deductible. But those deductions are phase out if these two conditions are met:

1. Your modified adjusted income (MAGI) exceeds a specified level, and
2. You (or your spouse if you’re married) are an active participant in an employer-sponsored retirement plan.

So, depending on your situation, only a fraction of your traditional IRA contributions — if any — may be tax deductible.

Roth IRAs

Conversely, Roth IRA contributions are never tax-deductible, regardless of your MAGI. But as long as the account is at least five years old, qualified distributions are 100% tax-free. Qualified distributions include withdrawals that are:

• Made after age 59 ½
• Made on account of death or disability
• Used to pay qualified first-time homebuyer expenses ($10,000 lifetime limit)

Non-qualified Roth IRA distributions are taxed at ordinary income rates under special “ordering rules.” When you take a distribution, contributions are treated as coming out first, so this part is exempt from tax if the contributions weren’t deductible. This treatment is followed by conversion and rollover amounts and, finally, earnings. These ordering rules reduce any potential tax liability during the first five years of the account’s existence.

Basically, when you convert a traditional IRA to a Roth, you’re usually doing it for future tax-free payouts. But that doesn’t mean you should definitely convert.

Factors to Consider

You used to be able to reverse (or “recharacterize”) a conversion by October 15 of the same year. You might do this if the assets in the converted account suddenly declined. But because of the Tax Cuts and Jobs Act (TCJA), that provision was eliminated beginning in 2018. Now you can no longer recharacterize your Roth IRA back to a traditional IRA.

So if you are thinking of converting, you should be sure, because it is permanent. Here are a few questions you should ask yourself when deciding to make a conversion or not.

How much tax will you owe?

You must pay a tax on the funds transferred from your traditional IRA to Roth IRA. If your balance is high and you expect a drop in value after the conversion, you may not want to convert.

Do you have money to pay the conversion tax bill?

The more money you convert and the higher your tax bracket, the bigger the tax bill. If the taxes on your converted assets exceed the cash you have on hand, you may need to dip into your retirement funds to cover the difference. You may pay the taxes out of your converted funds, which will decrease your assets.

What is your retirement horizon?

Stage of life also impacts your conversion decision. Usually, you wouldn’t want to convert a traditional IRA if you expect to retire and start drawing down the account in the near future. You want to give your new Roth IRA time to grow, appreciate and compound over time to make up for the tax hit you took when making the conversion.

How do you expect your tax rate to change in retirement?

If you think you’ll be in a lower tax bracket than you are now, an IRA conversion may not be in your best interest. Instead, it may be easier to absorb the tax on distributions later than it is to pay the conversion tax now. Conversely, if you expect to be in a higher tax bracket upon retirement, a conversion now could make sense. Of course, Congress could always change tax rates in the future, which does complicate the decision.

Will you have other sources of retirement income, besides your IRAs?

If a majority of your retirement is invested in assets that would trigger taxes upon distributions (such as stocks that grow in value or a 401(k) plan), converting to a Roth could be useful. Because each withdrawal is tax-free, it can provide flexibility and tax diversification later in life. This is especially important as there’s no telling what the tax rates may look like in the future.

Required Minimum Distributions

You should also factor required minimum distributions (RMDs) into your decision. Traditional IRAs dictate that you must begin taking RMDs by April 1 of the year after you turn 72. For each subsequent tax year, an RMD must be made by December 31 of that year.

With a Roth IRA, however, there are no mandatory lifetime distributions. So you can decide when (and even if) you draw on the account, which can help preserve wealth for your heirs.

What’s Right for You?

If you’re looking for more personal insights and advice on whether you should convert a traditional IRA to a Roth IRA, contact us at Filler & Associates.