Converting Traditional IRAs to Roths

If you had to choose, would you rather pay income tax on $10,000 today, or $20,000 in 10 years or so? How about paying tax on $40,000 in two decades? That's the question we face each year when we decide to fund a traditional retirement plan or a Roth.

Roth IRAs backfired—on the government. They were created by the Taxpayer Relief Act of 1997. Senator William Roth of Delaware sought to restore the universal IRA, which had been eliminated for most by the Tax Reform Act of 1986. Congressional rules prohibited this, because the expected loss of revenue over the next 10 years was significant. Instead, Roth designed a retirement account with non-deductible contributions and tax-free distributions in retirement. This circumvented the rules because most of the lost revenue would occur beyond the 10-year measuring period. It turned out that the potential lost revenue caused by the Roth IRA could be much, much greater than that caused by the traditional IRA. This created an opportunity for the taxpayer.

Today Roths account for more than $660 billion of the $7.9 trillion held in individual retirement accounts at the end of 2016. They are especially popular among younger investors, with those under 40 years of age twice as likely to have a Roth IRA as a traditional IRA. Forty-seven percent of IRA assets, or $3.7 trillion, were held in mutual funds.[1]

If we've paid off our home by the time we retire and don't have an extravagant lifestyle, we might not need a large, taxable income. Most middle-income earners are entitled to about $25,000-$30,000 a year from Social Security. If both spouses worked, it might be twice that amount, and this is adjusted for inflation during the retirement years.  If our retirement plan is worth $1 million when we reach age 70, our first required minimum distribution (RMD) from it might be roughly $36,500, making our combined income nearly $100,000 that year.

The problem can snowball as time goes on. If we limit our IRA withdrawals to RMDs, and the account is invested in equities, it should grow in the mid-single digits a year, and our RMD could nearly double by the time we reach age 80. If so, our total income would be close to $137,000, not counting the cost of living increases of Social Security. We might not need that much, but by law we must take it. Under the same assumptions, by the time we're 90 our RMD could grow to over $100,000, and who knows how much our Social Security will be? What the tax bite will be on all this income? Admittedly this is a wonderful problem to have—a great improvement over our humble beginnings—but is there anything a person can do to soften the tax hit?

Yes, it's called a Roth conversion. We can take annual distributions from our retirement plan, pay the tax each year and roll the funds into a Roth IRA. We may even have a Roth option in our employer's 401(k) to use. In addition to offering tax-free distributions, there is no RMD for either the owner of the Roth or his or her spouse. Anyone who inherits a Roth must take RMDs, but they are not taxable.

It's not an all-or-none proposition. The conversions can be performed many times over the years. The tax should be paid out of pocket, not from distributions from the retirement plan. Obviously, it would be best to convert during times of market weakness, before the market bounces back from a decline. This would reduce the tax on the distribution and allow the expected rebound to occur in the tax-free environment of the Roth. However, since we can never know when a decline might occur a regular, annual conversion process is recommended. If the market should create an opportunity to convert more, we can take advantage of it.

Not only can the Roth Conversion be an advantage to us, but there might be a terrific benefit for our children. If children inherit a traditional retirement plan from a parent, they must continue taking distributions. If the children are in their peak earning years, the distributions are taxable at their high tax rates.

Retirement plan funds that have been converted to Roth status are subject to RMDs at the children's ages, but the funds are not taxable. Now here's a wrinkle that might make you smile. If the children are comfortable financially, they might not need the additional income. If so, they can increase their own Roth contributions to the maximum $18,000 a year ($24,000, if over 50) and use the annual distribution received to make up for the funds contributed. When the time comes they should have their own significant Roth account to pass on to their children, and this legacy was made possible in part by their parents.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. Traditional IRA account owners should consider the tax ramifications, age and income restrictions regarding a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.


[1] Investment Company Institute, “Ten Important Fact About Roth IRAs,” July 2017.