By Roger Wohlner
Does a Roth conversion make sense for me?
Like most issues in the realm of financial planning, the answer to this question is: It depends. Roth accounts offer a number of advantages including the opportunity for tax-free withdrawals and in the case of a Roth IRA, an exemption from required minimum distributions , or RMDs. However, doing a Roth conversion involves paying taxes on the amount converted now.
Here are some things to consider in determining whether a Roth conversion makes sense for you.
Taxes – now or later?
Perhaps the most crucial issue in determining whether or not a Roth conversion makes sense for you are taxes. Specifically, what is your current tax bracket and what is your anticipated tax bracket in retirement?
Money converted to a Roth IRA or 401(k) is taxed in the year of the conversion. If you are in a high tax bracket, the conversion would be taxed at that higher rate and could even push you into a higher tax bracket. It can make a lot of sense to do Roth conversions in years where your income is lower than normal if applicable to your situation.
The benefit, of course, is that money in a Roth account is not taxed if certain conditions are met. Money in a Roth IRA is not subject to required minimum distributions and can be allowed to grow uninterrupted on a tax-free basis. Money in a Roth 401(k) is subject to RMDs, but these distributions are not generally taxed. This can be avoided by rolling money in a Roth 401(k) to a Roth IRA once you leave that employer.
Your age matters on a couple of levels. If you are in or near retirement the five-year rule on Roth conversions can come into play. One of the criteria used to determine if a withdrawal from a Roth IRA is a qualified distribution that is not subject to taxes or a penalty is whether or not the account owner has satisfied the five-year rule. Each Roth conversion has its own so-called five-year clock.
The five-year rule pertains to time that needs to elapse after a contribution to a Roth or a Roth conversion before which a withdrawal can be considered to be a qualified distribution. The five-year rule is one of several criteria in making this determination.
Another age-related issue surrounding a Roth conversion is how long will it take the funds invested in the Roth account to earn enough to offset the impact of the taxes paid on the conversion. For someone who is younger, say in their 40s, they have a number of years to let the converted funds appreciate to hopefully more than offset the impact of the taxes. Someone who does a conversion in their 60s or 70s does not have as much time for this to happen.
Required minimum distributions
One of the biggest advantages of a Roth IRA is the fact that these accounts are not subject to required minimum distributions as with a traditional IRA or 401(k). While a Roth 401(k) is subject to RMDs, this can be avoided by rolling this money over to a Roth IRA once you leave that employer.
RMDs begin at age 72 and can deplete a traditional IRA or 401(k). RMDs are mandatory based on an IRS schedule and these distributions are taxed as ordinary income each year. For those who don’t need the money from the RMDs or who would like to diversify the tax situation of their retirement accounts, a Roth conversion can be a good tool to reduce future RMDs.
You will want to weigh the cost of the Roth conversion, the taxes paid in the year of the conversion, against the future benefit of reducing your RMDs. Will the tax savings offset the taxes paid on the converted amounts? In order to determine this you will need to make some assumptions regarding your tax bracket in retirement. These assumptions may get thrown out the window based on the direction that tax rates take due to future legislation.
The SECURE Act which went into effect at the beginning of 2020 changed the landscape for inherited IRAs. The ability for most nonspousal beneficiaries to stretch out their account distributions has been replaced with a requirement that all assets from inherited IRAs must be distributed within 10 years.
In the case of an inherited traditional IRA, this can sharply reduce the amount the beneficiary actually gets to keep after taxes. Inherited Roth IRAs must also be fully distributed within 10 years, but the distributions are tax-free as long as the account holder had satisfied the five-year rule prior to their death.
For those who have nonspousal beneficiaries who will be subject to the 10-year rule, converting to a Roth IRA can help you meet the five-year rule. It can also be a way to cover the taxes for your beneficiaries via you paying the taxes on the conversion versus leaving the money in a traditional IRA that would subject the heirs to potentially high taxes on the inheritance.
Do you have the money to pay the additional tax?
A Roth conversion triggers a current year tax liability. Before deciding to move forward with a Roth conversion make sure that you have sufficient cash outside of any of the account(s) being converted to cover the taxes you will incur due to the conversion.
A failure to have sufficient cash on the side to cover taxes can make the conversion very expensive. This could require that you withdraw additional funds from a traditional IRA or elsewhere incurring additional taxes over and above what would be due from the conversion itself.
Additionally, any additional money withdrawn from an IRA or another account is money that loses the opportunity to be invested and grow in value.
A Roth conversion is a solid financial planning tactic, but make sure you examine all of the factors related to your unique situation.