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What you should know about a Roth IRA conversion

Should a Roth IRA conversion be part of your investment strategy?

One financial strategy that is often overlooked when evaluating your retirement and estate planning options is the Roth IRA conversion. Learning more about a Roth IRA conversion may be a sensible step whether you are designing a comprehensive estate plan, trying to maximize your legacy for younger family members, or seeking tax-free income opportunities in retirement. Converting allows you to reposition your current tax-deferred Traditional IRA or qualified employer sponsored retirement plan (QRP) to a tax-free Roth IRA by paying federal and possibly state income tax (but without the IRS 10% additional tax for taking early or pre-59½ distributions) on the taxable amount of the conversion. It is important to remember that you must have a triggering event, such as separation of service, to be eligible to make distributions from your QRP. Remember, you generally do not have to sell the account assets as they can be converted as an “in-kind” transfer.

Roth IRAs possess characteristics that make them generally attractive planning tools; for example, they are not subject to required minimum distribution (RMD) rules during the life of the original account owner, which means that you can use them as an estate planning tool for passing money to your heirs. However, you should understand your tax situation and ability to pay for the conversion. Because, once you convert, you can no longer recharacterize, or undo the conversion.

Here are four reasons a Roth conversion may be appropriate:

  1. Market conditions may have decreased the value of the assets in your retirement accounts, therefore, you may owe less in taxes on the conversion than if your account values had increased. When you convert all or a portion of your retirement accounts to a Roth IRA, you will owe taxes on any tax-deductible contributions as well as any earnings that may have built up in the account over the years.
  2. If you expect your portfolio’s value to recover in the future, converting when the market is down means any earnings in the Roth IRA would potentially grow on a tax-advantaged basis and qualified distributions are tax-free.*
  3. If you expect that future tax rates will be higher when you begin to take distributions, converting and potentially paying at a lower tax rate now might make economic sense.*
  4. Your beneficiaries can distribute earnings tax-free from an Inherited Roth IRA as long as the Roth had been funded for more than five years.

Here are four reasons a Roth conversion may not be appropriate:

  1. You don't have funds in a non-retirement account to pay the taxes. Remember, taking a distribution from your Traditional IRA or QRP to pay the taxes due on the Roth conversion will result in additional income taxes, loss of tax deferral, and if you are under 59 1/2, a 10% additional tax for early or pre-59 1/2 distributions.
  2. You will be relocating to a state with no or lower state income tax.
  3. You will be in a lower tax bracket in retirement.
  4. The conversion pushes you into a higher tax bracket.

If your employer’s qualified retirement plan offers a designated Roth account option, you also may want to consider making contributions to this account. Designated Roth account assets can be rolled over only to a Roth IRA or another employer’s designated Roth account, if that plan accepts the rollover.

Everyone has a different vision of retirement that requires a unique financial strategy; contact your financial advisor to discuss if a Roth IRA conversion is right for you. You should also consult your tax, and legal advisors before taking any action that may have tax or legal consequences and to determine if a Roth conversion is appropriate for your specific situation.

*Qualified Roth IRA distributions are not included in gross income. Roth IRA distributions are “qualified” provided a Roth IRA has been open for more than five years and the owner has reached age 59 1/2 or as a result of your disability, or using the first time homebuyer exception, or taken by your beneficiaries due to your death. You may owe an IRS 10% additional tax for early or pre-59 1/2 distributions.

Roth IRA conversions are not appropriate for all individuals. Wells Fargo and Company and its Affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.

Please keep in mind that rolling over your qualified employer sponsored retirement plan (QRP) assets to an IRA is just one option. Each option has advantages and disadvantages, and the one that is best depends on your individual circumstances. You should consider features such as investment options, fees and expenses and services offered. Investing and maintaining assets in an IRA will generally involve higher costs than those associated with a QRP. We recommend you consult with your plan administrator before making any decisions regarding your retirement assets.