Should I Consider A ROTH Conversion?

By: Brian Seay, CFA

What is a ROTH Conversion?

A ROTH Conversion is a financial strategy that involves transferring funds from a traditional Individual Retirement Account (IRA) or a 401(k) into a ROTH IRA. This process requires the account holder to pay income taxes on the amount being converted at the time of the conversion. The primary appeal of a ROTH Conversion is that once the funds are in the ROTH IRA, they can grow tax-free, and qualified withdrawals in retirement are also tax-free. This can be particularly advantageous for individuals who anticipate being in a higher tax bracket in the future or who desire tax-free withdrawals in retirement.

Why Should an Individual Consider a ROTH Conversion?

Potential Tax Savings

The main reason to do a ROTH Conversion is to save taxes over the course of your lifetime. If you expect your income to be lower now vs. later in retirement, it might be an opportune time to do a ROTH Conversion while paying taxes at a lower rate. Let’s look at a couple of charts to illustrate how it works. First, implicit in all of this, is that you are doing tax planning. You need to understand what your tax rate is today and what it may be in future years, especially in your 70s and 80s when you will be required to begin taking funds out of your traditional IRAs and 401ks. On the chart, you can see taxable income in the bars and the tax brackets in the colored horizontal lines. Overtime, your income grows and so does your effective tax rate. The conversion accelerates some of that taxable income so that you pay taxes on it when you are in lower tax bracket years. You can see on the second chart that you pay more in taxes in the conversion years (red bars) in exchange for savings in later years (green bars).

Tax-Free Growth and Withdrawals

ROTH IRAs offer the unique benefit of tax-free growth and tax-free withdrawals during retirement. This can be a significant advantage for those who expect to be in a higher tax bracket in the future or who want to avoid the uncertainty of future tax rates.

No Required Minimum Distributions (RMDs)

Unlike traditional IRAs and 401(k)s, ROTH IRAs do not require account holders to take Required Minimum Distributions (RMDs) starting at age 72. This allows the funds to continue growing tax-free for a longer period and provides more flexibility in retirement planning.

Estate Planning Benefits

ROTH IRAs can be an effective tool for estate planning. Since ROTH IRAs do not have RMDs, account holders can pass on the entire amount to their heirs. Beneficiaries can then enjoy tax-free withdrawals, providing a lasting financial legacy.

Tax Diversification

Having a mix of tax-deferred, taxable, and tax-free accounts can provide greater flexibility in managing taxes during retirement. A ROTH Conversion can help achieve this diversification, allowing retirees to strategically withdraw funds to minimize their overall tax liability.

When Should Someone NOT Do a ROTH Conversion?

High Current Tax Bracket

If an individual is currently in a high tax bracket, the cost of converting traditional retirement funds to a ROTH IRA could be prohibitively expensive. Paying taxes at a high rate now may outweigh the potential future benefits of tax-free withdrawals.

Lack of Outside Funds to Pay Taxes

Performing a ROTH Conversion requires paying income taxes on the amount converted. If an individual does not have sufficient funds outside of the retirement account to cover the tax bill, it may not be a wise decision to proceed with the conversion. Using retirement funds to pay the taxes can erode the benefits of the conversion.

Approaching Retirement

For individuals who are close to retirement and expect their income to significantly decrease, it may be more advantageous to wait and take withdrawals from traditional accounts at a lower tax rate rather than converting to a ROTH IRA now.

Uncertainty of Future Income

If there is significant uncertainty regarding future income or tax rates, it may be challenging to determine whether a ROTH Conversion is the best course of action. In such cases, maintaining flexibility with traditional retirement accounts might be preferable.

What Are the Drawbacks and Limitations of a ROTH Conversion?

Immediate Tax Liability

One of the most significant drawbacks of a ROTH Conversion is the immediate tax liability incurred. Converting funds from a traditional IRA or 401(k) to a ROTH IRA means paying income taxes on the converted amount in the year of the conversion. This can result in a substantial tax bill, particularly for individuals with large account balances.

Impact on Income-Related Programs

The additional income generated by a ROTH Conversion can affect eligibility for income-related programs and benefits, such as Medicare premiums, Social Security taxes, and financial aid for dependents. It is essential to consider these potential impacts when planning a ROTH Conversion.

Market Timing Risks

The decision to convert funds to a ROTH IRA involves market timing risks. If the value of the investments decreases after the conversion, the individual would have paid taxes on a higher amount than the current value. Conversely, if the investments appreciate significantly, the conversion could prove advantageous.

5 Year Rule

ROTH Conversions generally require the funds to remain in the ROTH for 5 years after the conversion to receive the full tax benefits. You need to make sure you have other funds to meet your goals over that period of time. Conversions ofter occur over several years, so you need to be able to track each seperate conversion to understand when you can withdraw funds in retirement.

Opportunity Cost

By paying taxes upfront on the converted amount, individuals lose the opportunity to invest those funds elsewhere. It is crucial to weigh the potential long-term benefits of a ROTH Conversion against the immediate cost of paying taxes.

Conclusion

ROTH Conversions can be a powerful tool for retirement planning, offering tax-free growth and withdrawals, no Required Minimum Distributions, and potential estate planning benefits. However, they also come with significant drawbacks, including immediate tax liability, potential impact on income-related programs, market timing risks, administrative complexity, and opportunity costs.

The changes introduced by the 2017 Tax Cuts and Jobs Act, particularly the elimination of recharacterizations and the temporary lower tax rates, have made ROTH Conversions more appealing in the short term. However, with the potential expiration of these provisions at the end of 2025, individuals must carefully consider their unique financial situations and long-term goals when deciding whether to pursue a ROTH Conversion.