A Roth conversion can be a powerful tax planning strategy leading up to and in retirement—especially if you exceed the income threshold for contributing directly to a Roth IRA. Indeed, the benefits of a Roth conversion include tax-free distributions in retirement and the elimination of required minimum distributions (RMDs).

Yet Roth conversions don’t make sense for everyone. Thus, it’s important to weigh the costs against the potential benefits, as well as alternative tax planning strategies, before moving forward.

What Is a Roth Conversion?

The IRS allows individuals—regardless of income—to convert a traditional IRA to a Roth IRA. A Roth conversion shifts your tax liability to the present, so you avoid paying taxes on withdrawals in the future.

Here’s how it works:

• With a Roth conversion, you pay taxes on the amount you convert at your current ordinary income tax rate.
• After you convert your traditional IRA to a Roth, any withdrawals you make in retirement will be tax-free if you’re over age 59 ½ and satisfy the five-year rule.
• Since Roth IRAs don’t have RMDs, you can leave your funds to grow tax-free until you need them.

A Roth conversion can be particularly valuable in years when your income is below average, and you fall into a lower tax bracket. Nevertheless, there are a variety of factors to consider before converting your traditional retirement account funds to a Roth.

Here are 5 questions to ask yourself if you’re considering a Roth conversion:

#1: Is a Roth conversion a smart tax move right now?

In general, a Roth conversion makes sense if you expect your tax rate to be higher in the future than it is today. Thus, the most important question to ask yourself before a Roth conversion is, “Will paying taxes on the funds I convert today save me money in the long run?”

Of course, tax laws can change, and it’s impossible to predict the future. That’s why many people choose to take advantage of this strategy in years when their income is below average.

For example, if both you and your spouse work full-time, earn high incomes, and file a joint tax return, you may be in the highest tax bracket most years. But perhaps your spouse loses a large client, cutting their income in half for the year and lowering your joint income enough to temporarily put you in a lower tax bracket. In this case, a full or partial Roth conversion might make sense since your tax rate is lower than normal.

Alternatively, a Roth conversion may also be a smart tax move in years when the market is down. In most cases, your account balance will also drop alongside the market, reducing the dollar amount you convert. As a result, you’ll likely pay less in taxes than you would have before the market dropped.

While the concept of a Roth conversion may be relatively straightforward, the math can be complex. Be sure to work with a financial planner or tax expert, who can advise you on the best time to implement this strategy.

#2: How will a Roth conversion affect other aspects of my financial plan?

Depending on the amount of money you convert to a Roth IRA, your taxable income can increase substantially in the year you execute the conversion. Thus, it’s important to understand how a potential increase in taxable income may impact other areas of your finances—especially if you’re already in retirement.

For example, if you receive Social Security benefits, an increase in taxable income may trigger federal income taxes on your benefits. Currently, single filers earning more than $25,000 annually and joint filers earning more than $32,000 must pay federal income taxes on a portion of their benefits. Therefore, it’s important to know if a Roth conversion will push you over these thresholds.

In addition, an increase in your taxable income can impact your health insurance premiums if you’re in retirement.

For those who retire before age 65 and need to bridge the gap until you’re eligible for Medicare, an income boost may disqualify you from receiving The Premium Tax Credit. This credit helps subsidize the premiums lower earners pay on insurance through the Marketplace.

Similarly, retirees over age 65 may be subject to IRMAA, a surcharge you must pay in addition to your Medicare Part B and D Premiums if your income is over a certain amount.

#3: Do I have adequate tax diversification?

When planning for retirement, it’s often helpful to diversify your financial resources among various account types, including traditional (pre-tax) retirement accounts, Roth (after-tax) accounts, and taxable accounts. This can help you optimize your retirement income strategy and minimize your lifetime tax bill.

As a rule of thumb, it’s usually beneficial to have roughly a third of your assets in each type of account. So, if the majority of your assets are in pre-tax retirement accounts, a partial Roth conversion can help diversify your tax exposure.

On the other hand, converting all of your funds to a Roth IRA may push you too far in the opposite direction. While this isn’t necessarily problematic, it’s a good idea to work with a financial planner to determine your optimal mix of account types.

#4: Do I plan to transfer assets to the next generation?

One of the primary benefits of a Roth conversion is the elimination of required minimum distributions (RMDs). RMDs can increase your taxable income—even in years you don’t need them—and lower your retirement account balance over time.

Suppose you plan to leave your remaining assets to your children upon your death, for example. If most of your retirement funds are in a traditional IRA, you’ll have to take RMDs every year once you reach the applicable age (currently 73), gradually reducing its balance over time.

Even if you don’t spend your distributions, you’ll pay ordinary income taxes on them, lowering the amount you can leave your children. Plus, they’ll have to take taxable RMDs from the inherited IRA.

On the other hand, Roth IRAs don’t have RMDs. If you don’t need the income in retirement, you can let your funds appreciate tax-free within a Roth IRA, then transfer a potentially larger balance to your children upon your death. Moreover, your children can take tax-free withdrawals from the account upon inheriting it in most cases.

#5: Do I have enough cash on hand to pay taxes on the Roth conversion?

Finally, don’t forget you must pay ordinary income taxes on the amount you convert to a Roth IRA in the tax year you make the conversion. Thus, you’ll need to have enough cash on hand to pay your tax bill.

While you can pay the taxes with funds from your retirement account, most experts advise against this approach. That’s because withdrawing money from a tax-advantaged account can negate many of the tax benefits of doing the Roth conversion in the first place.

Meanwhile, if you liquidate funds from investments within a taxable account, you may end up triggering capital gains taxes. This can also diminish the benefits of converting to a Roth IRA.

Ideally, you’ll have enough cash available to avoid disrupting your investment accounts. If not, you may want to start raising cash in anticipation of a future Roth conversion.

Satori Wealth Management Can Help You Determine if a Roth Conversion Is Right for You

A Roth conversion can be a valuable tax and estate planning strategy. Yet due to its complexities, it may not right for everyone. Be sure to consult an experienced financial planner or tax expert to determine if this strategy makes sense for you.

Satori Wealth Management specializes in the financial planning needs of those nearing and in retirement. We can help you develop a retirement plan that considers your personal tax situation and helps you achieve your financial goals. Please schedule your complimentary RetireNow Checkup™ to see if we may be a good fit.