When does a Roth conversion make sense?

What a Roth conversion does

A traditional IRA generally holds money whose earnings have not yet been
taxed. It may also contain nondeductible contributions that create after-tax
basis. A conversion transfers all or part of an eligible traditional IRA to a
Roth IRA. Eligible workplace-plan money may also be rolled directly to a Roth
IRA, and some plans permit an in-plan Roth rollover.

The conversion is not the same as a regular Roth IRA contribution:

• regular Roth IRA contributions have annual contribution and income limits;
• the IRS says a person may be able to convert traditional IRA amounts
  regardless of adjusted gross income;
• a conversion does not create a deduction;
• the taxable portion is generally included in gross income for the conversion
  year; and
• a conversion or eligible-plan rollover to a Roth IRA made after 2017
  generally cannot be recharacterized as a traditional IRA.

The source account matters. Traditional, SEP, and SIMPLE IRAs can interact with
the IRA basis calculation. Workplace plans have their own distribution and
rollover rules. A designated Roth account inside a workplace plan is not the
same account type as a Roth IRA.

Start with the reason, not a target amount

A conversion should solve an identified planning problem. Possible reasons to
model one include:

• diversifying the tax character of future retirement withdrawals;
• evaluating a lower-income year between employment and later income sources;
• reducing the traditional-account balance that may produce future RMDs;
• preserving flexibility for large future expenses without adding the same
  amount of taxable IRA income;
• coordinating retirement income with survivor, charitable, or estate goals;
  or
• correcting an account mix that is heavily concentrated in pretax assets.

These are reasons to compare alternatives, not reasons to convert. A household
can value tax diversification and still decide that the current cost,
collateral effects, investment horizon, or uncertainty does not support a
conversion.

Define the objective in writing before choosing an amount. “Fill a bracket” is
an implementation shorthand, not an objective by itself.

Situations in which a conversion may deserve closer analysis

A temporarily lower-income year

Income can fall after retirement, a job change, a business transition, a
sabbatical, or the end of a compensation arrangement. There may also be a
period before Social Security, pensions, RMDs, or other income begins.

A lower-income year can create capacity to recognize additional income at a
lower marginal rate than in another modeled year. That conclusion must come
from a complete tax projection. Wages, investment income, capital gains,
business income, deductions, credits, Social Security benefits, filing status,
and state tax can change the result.

The projection should compare at least:

1. no conversion;
2. one or more partial-conversion amounts; and
3. the effect in later years under clearly identified assumptions.

Do not use a bracket ceiling as the only stopping point. Other thresholds can
create a higher effective marginal cost before the nominal bracket changes.

A long period before the converted money is expected to be spent

The benefit of Roth treatment generally has more time to develop when the
converted amount can remain invested. A short expected holding period can make
the upfront tax and the Roth distribution rules more important.

Time alone does not prove that a conversion is favorable. Expected returns,
investment risk, future withdrawals, account fees, tax rates, beneficiary
rules, and the source of the tax payment all affect the comparison.

Sufficient liquidity outside the retirement account

Paying the resulting tax from cash or another nonretirement source can leave
more of the converted amount in the Roth account. Using part of the retirement
distribution for withholding or spending means less reaches the Roth account
and can create additional early-distribution issues for some taxpayers.

Outside cash is not “free.” Compare its emergency, spending, investment,
borrowing, and estate uses before assigning it to a conversion tax payment.

A desire to reduce future pretax balances

Traditional IRAs generally become subject to lifetime RMD rules. Roth IRAs do
not require distributions during the original owner's lifetime, although
beneficiaries remain subject to distribution rules.

A conversion can reduce the balance left in a traditional IRA, but it should
not be described as eliminating RMDs or taxes. Other traditional accounts may
remain, tax is accelerated on the converted amount, and future law and account
values are uncertain.

A need for more tax-character flexibility

Holding taxable, tax-deferred, and Roth assets can provide different sources
for future spending. A qualified Roth IRA distribution generally does not add
the same taxable income as a traditional IRA distribution. That may create
planning flexibility in a year with a large purchase, healthcare threshold, or
other income event.

This is not a promise that a Roth withdrawal will always be tax-free or that it
will improve a particular benefit. Qualification, ordering, and beneficiary
rules still matter.

Situations in which a conversion may be less attractive

The current marginal cost is high

If the conversion falls in a high-tax year, the household may pay tax sooner
at a rate that is not supported by the later-year projection. Large bonuses,
business income, stock compensation, capital gains, severance, pension
payments, and other events can make the same conversion amount more expensive
in one year than another.

“Taxes are historically low” or “rates will rise” is not enough. The relevant
comparison is the household's modeled marginal cost now against reasonable
future scenarios, with uncertainty stated.

The converted money may be needed soon

A near-term withdrawal can weaken the case for paying tax early and can expose
the household to Roth IRA qualification and conversion five-year rules. A
person under age 59 1/2 who withdraws a taxable conversion amount within its
separate five-year period may owe the additional tax unless an exception
applies.

Liquidity needs, emergency reserves, planned purchases, healthcare, and
possible long-term-care spending belong in the review before a conversion.

The added income affects another tax or benefit

Conversion income can change adjusted gross income or modified adjusted gross
income used by other rules. Depending on the household, the effects may
include:

• Medicare Part B or Part D income-related monthly adjustment amounts;
• Marketplace premium tax credits;
• the taxable portion of Social Security or equivalent Tier 1 railroad
  retirement benefits;
• the net investment income tax on other net investment income;
• deductions, credits, or other income-based provisions;
• estimated-tax or withholding requirements; and
• state income tax.

The conversion itself is not necessarily the income subject to each separate
tax. For example, the net investment income tax applies to specified net
investment income, but higher modified adjusted gross income can affect how
much of that tax applies. Model the rule correctly instead of adding every
listed percentage to the conversion.

The tax payment would weaken the rest of the plan

A conversion can be unaffordable even if a long-range tax model looks
favorable. Do not use funds needed for near-term spending, emergency reserves,
debt obligations, insurance, business operations, or another higher-priority
goal without comparing the trade-offs.

Borrowing to pay conversion tax introduces interest, repayment, and liquidity
risk. It should not be presented as a routine funding method.

Charitable plans change the comparison

A person who expects to make qualified charitable distributions or leave
traditional IRA assets to charity may have a different comparison from someone
who expects to spend the account or leave it to individuals. The tax treatment,
age and eligibility requirements, beneficiary designations, and estate plan
should be reviewed with qualified professionals.

Do not assume that converting money intended for charity produces the same
result as converting money intended for household spending.

Model the conversion's full marginal cost

The conversion amount is not the tax bill. The taxable portion joins the
household's other income, and the incremental cost depends on the return and
the rules that use income.

Build a year-specific projection with:

• filing status and expected taxable income before the conversion;
• wages, business income, pensions, annuities, Social Security, and other
  retirement distributions;
• interest, dividends, capital gains, losses, and property transactions;
• deductions and credits;
• tax-exempt interest and other items included in a relevant MAGI definition;
• health coverage and Medicare status;
• traditional IRA basis and year-end IRA balances;
• RMDs that must be distributed first;
• federal and state tax;
• withholding and estimated payments; and
• the proposed conversion amount.

Then calculate the incremental result:

projected total tax and related costs with conversion

minus

projected total tax and related costs without conversion

Divide the difference by the amount converted only as a descriptive effective
cost for that modeled increment. It is not a return forecast and does not prove
that the conversion will pay off.

Run more than one amount. A single all-or-nothing projection hides where
brackets, premiums, credits, or other effects change.

Medicare premiums can reflect income from two years earlier

Social Security generally uses federal tax-return information from two years
before the Medicare premium year when determining income-related adjustments
for Part B and Part D. A conversion can therefore affect premiums after the
conversion year rather than immediately.

The thresholds and premium amounts change. Use the current Social Security
table for the relevant premium year rather than copying an old number into a
multi-year plan.

Form SSA-44 permits a person to request a lower IRMAA determination after
certain life-changing events and a reduction in income. Do not assume a
voluntary Roth conversion is itself a qualifying life-changing event or that
an appeal will remove its effect. Review the current form and the person's
facts.

Marketplace coverage requires a current income estimate

Marketplace premium tax credits use household income and modified adjusted
gross income rules. A conversion can increase AGI and change the final credit.
HealthCare.gov tells enrollees to report income and household changes promptly;
using more advance credit than the final return supports can result in
repayment.

Before converting, a Marketplace enrollee should have a qualified tax
professional model the final premium tax credit and should update the
Marketplace application as required. Do not rely only on the current monthly
premium.

Social Security benefit taxation can change

Federal taxation of Social Security benefits depends on a calculation that
includes other income and one-half of benefits. Conversion income can increase
the taxable portion of benefits for some recipients.

Use the current IRS Publication 915 worksheet or tax software appropriate to
the year. Do not describe the effect as an additional fixed “Social Security
tax,” and do not assume every recipient reaches the same taxable percentage.

The net investment income tax requires a separate calculation

The conversion is retirement-account income, not automatically net investment
income. However, the net investment income tax applies to the lesser of net
investment income or the amount by which the applicable MAGI exceeds the
statutory threshold. Increasing MAGI through a conversion can therefore change
the tax applied to a household's separate net investment income.

Use Form 8960 and its current instructions. Do not apply 3.8% mechanically to
the full conversion.

Identify pretax money and basis before converting

Traditional IRAs can contain:

• deductible contributions and earnings that generally have not been taxed;
• nondeductible contributions tracked as basis;
• rollovers from workplace plans; and
• amounts held in traditional SEP or SIMPLE IRAs.

Form 8606 reports nondeductible traditional IRA contributions, relevant
distributions, and conversions. Its calculation generally looks across the
taxpayer's traditional IRAs, including traditional SEP and SIMPLE IRAs, rather
than letting a taxpayer select only the after-tax dollars in one IRA.

Before choosing an amount, gather:

• every prior Form 8606;
• year-end statements for all traditional, SEP, and SIMPLE IRAs;
• Forms 1099-R and 5498;
• records of deductible and nondeductible contributions;
• rollover records from employer plans; and
• any inherited, beneficiary, or employer-plan account records that require
  separate treatment.

Missing basis records are a tax-preparation issue. Do not assume the entire
conversion is taxable, and do not assume an unsupported portion is tax-free.

Take any required distribution before converting additional money

An RMD is not an eligible rollover distribution and cannot be converted to a
Roth IRA. A person subject to an RMD generally must first distribute the
required amount. Only an additional eligible amount may then be considered for
conversion.

RMD rules differ among IRA and plan types, original owners and beneficiaries,
and working and retired participants. Confirm the required amount with each
administrator and the tax professional rather than treating one account's
withdrawal as satisfying every plan.

Understand both Roth IRA five-year rules

“The five-year rule” can refer to more than one rule.

Qualified-distribution five-year period

For Roth IRA earnings to be part of a qualified distribution, the distribution
must satisfy the applicable five-year period and an age, death, disability, or
first-home condition described by the IRS. The period generally begins with
the first tax year for which a contribution was made to a Roth IRA set up for
the owner.

Separate conversion five-year periods

A separate five-year period applies to each conversion or eligible-plan
rollover for purposes of the possible additional tax on an early distribution
of taxable converted amounts. The rule is particularly important for someone
under age 59 1/2 who may need the converted money.

Roth IRA ordering rules generally treat regular contributions first,
conversion and rollover contributions next on a first-in, first-out basis, and
earnings last. The taxable and nontaxable portions of conversion contributions
also have an ordering rule.

Do not simplify these rules to “wait five years and everything is tax-free.”
Age, account history, contribution type, conversion year, distribution order,
and exceptions matter.

A completed conversion generally cannot be undone

The IRS permits some regular IRA contributions to be recharacterized, subject
to the applicable rules and deadline. It does not permit a post-2017 conversion
or eligible-plan rollover to a Roth IRA to be recharacterized as traditional.

That makes the pre-conversion projection and record review important. Market
declines, unexpected income, a changed filing status, or a mistaken estimate
generally do not recreate the old conversion reversal.

Partial conversions can limit the amount exposed to estimation error, but they
do not guarantee a better result and each still requires correct execution and
reporting.

Use a controlled implementation process

After the decision is approved by the taxpayer and appropriate professionals:

1. Confirm the source. Identify the exact IRA or plan, money types, basis,
   RMD status, distribution rights, and any SIMPLE IRA or plan-specific rule.
2. Confirm the destination. Verify that the Roth IRA or plan accepts the
   transaction and obtain its exact instructions.
3. Confirm the amount. Update the tax projection for actual income,
   realized gains, deductions, credits, and year-to-date transactions.
4. Confirm the payment plan. Determine with the tax professional whether
   withholding, estimated payments, or another method is appropriate and which
   funds will be used.
5. Prefer documented institution-to-institution instructions where
   appropriate. A direct transfer or direct rollover can reduce operational
   and withholding risk, but the custodian and plan must confirm the available
   method.
6. Retain records. Keep confirmations, statements, Forms 1099-R and 5498,
   prior and current Forms 8606, and the tax projection.
7. Verify completion. Confirm the amount reached the intended Roth account,
   the account registration is correct, and the assets are invested according
   to the approved investment decision.
8. Reconcile the tax return. Give the records to the tax preparer and
   confirm that the conversion and any basis are reported correctly.

Do not wait until the final business day of the year. Financial institutions
and employer plans can have processing deadlines, and the transaction must be
completed and reported in the intended tax year.

Roth-conversion comparison worksheet

Use one row per modeled conversion amount.

The worksheet is a comparison aid, not tax software. The tax professional
should calculate the return-specific amounts and identify provisions not
listed here.

Questions to answer before a Roth conversion

Account and tax records

• Which account and money type would be converted?
• Is any of the amount already-taxed basis?
• Are all prior Forms 8606 and rollover records available?
• Are there traditional SEP or SIMPLE IRA balances?
• Is an RMD due, and has it been distributed correctly?
• Does a workplace plan permit the requested distribution or in-plan rollover?

Current-year projection

• What is expected income before the conversion?
• What amount is taxable?
• What are the incremental federal and state effects at several conversion
  amounts?
• Could the conversion change Medicare premiums, Marketplace credits, Social
  Security taxation, NIIT, deductions, or credits?
• How will withholding or estimated payments be handled?

Household plan

• What objective does the conversion serve?
• When may the money be needed?
• What funds would pay the tax?
• What other uses compete for that liquidity?
• What future withdrawal and tax-rate scenarios were tested?
• How do survivor, charitable, and beneficiary goals affect the comparison?

Execution and review

• Which institution is responsible for each step?
• What processing deadline applies?
• How will the transaction be documented?
• Who will verify Forms 1099-R, 5498, and 8606?
• When will the next conversion decision be reviewed?