Is a Roth conversion right for you?
While Roth conversions can be truly beneficial for some people, it’s critical to keep the big picture – both now and later – in mind when evaluating whether it’s right for you.
First, what is a Roth conversion?
Let’s start by describing the difference between a pre-tax or traditional retirement account and a Roth account. A pre-tax account in your employer retirement plan allowed you to deduct the amount you contributed to the account from your taxable income in the years you made contributions. A Traditional IRA account may have allowed you to take a deduction in the year you made a contribution, depending on your income level. When you take distributions from a Traditional or pre-tax retirement account, the majority of the distribution will likely be taxable. However, when you take a qualified distribution from a Roth account, the distribution will not be taxable. In addition, you do not pay income taxes on transactions or growth in either type of account while the funds remain in the retirement account. This means that the growth on your investments in your Roth accounts can ultimately be tax-free!
A Roth conversion occurs when we move dollars from a pre-tax or Traditional retirement account to a Roth account. You will have to pay taxes on the amount of the conversion in the year of the conversion (unless you weren’t able to deduct the original contribution).
Should you consider a Roth conversion?
Whether a Roth conversion makes sense for you depends on various factors in your financial situation. For instance, how much time do you have before you need to access the funds? How much do you have in tax-deferred retirement accounts? What is your current tax rate? What do you expect your tax rate to be in the future? What effect would the conversion have on your current taxes? What do you expect the effect to be in the future?
The time factor
One of the biggest benefits of Roth accounts is the tax-free nature of the growth. The more growth in the account, the greater the benefit. As long as you follow the rules for qualified distributions, your growth will ultimately be tax-free! Due to compounding, the longer you can allow the assets to grow before withdrawing them, the more dollars you’ll have that you can withdraw tax-free.
However, this doesn’t necessarily mean that you shouldn’t consider Roth conversions if you only have a few years until retirement. There are other reasons to consider Roth conversions.
RMDs
One of the other benefits of Roth accounts over other retirement accounts is that they don’t have Required Minimum Distributions or RMDs. Required Minimum Distributions are amounts that you are required to take annually from tax-deferred retirement accounts upon reaching a threshold age. The amounts are determined annually based on your age and the balance in your account. In cases where there are large balances in tax-deferred retirement accounts, RMDs can be large. These large distributions are taxable and can cause the retiree to be pushed into a higher tax bracket. In addition to the higher tax bracket, the additional taxable income can also subject the retiree to additional taxes and fees like the Net Investment Income Tax and the Income Related Medicare Adjustment Amount (IRMAA). These extra fees and taxes can take a significant portion of your income and wealth.
RMDs are essentially forced income. Read more about ways to handle forced income in our article.
The benefit of Roth conversions when it comes to future RMDs is that Roth accounts are not considered when calculating the amount of the RMDs. And, unless the Roth account is an inherited Roth, RMDs are not required from Roth accounts. Converting some tax-deferred dollars to Roth dollars not only removes the amount of the conversion from the calculation, it also removes all of the growth on that conversion amount from the calculation. So, a Roth conversion can help you manage not only future income taxes, but also supplemental taxes and fees like IRMAA.
What portion of your income goes to the government?
What percentage of your income goes to the government today in the form of taxes and fees? Considering your future income level and what you believe the future economic situation will be, what percentage of your income do you believe will go to the government in the future? Don’t forget to consider not only federal and state income tax, but also supplemental taxes like Additional Medicare tax, Net Investment Income tax, and the Income Related Medicare Adjustment Amount (IRMAA). When considering these numbers, it’s important to focus on the numbers that will affect you and your financial situation. For instance, IRMAA won’t affect everyone, but if it will affect you, you need to consider it in your calculation.
How would the event affect your taxes this year?
The Roth conversion process is simple. But it is considered an event. As we said, a Roth conversion will incur taxes in the year of the conversion. Therefore, part of the decision needs to factor in cash flow. Will you have the cash available to pay the extra taxes incurred this year?
What are the other current effects of the conversion?
Will you be incurring a Medicare surcharge due to the conversion? The conversion will increase your Adjusted Gross Income which could affect your Medicare premium if you are currently or will soon be on Medicare. Will the additional income push you out of eligibility for any tax credits? Are you receiving any benefits or financial assistance (including college financial aid) that could be lost due to the additional income that would be reflected on your tax return?
Flexibility
When contemplating a Roth conversion, also keep in mind the flexibility it provides in the future. When going through your annual income planning, having Roth dollars that you can use to meet spending needs without incurring higher income taxes or surcharges can be very helpful. Imagine being able to withdraw income for a big trip or renovation without having to worry about the negative impact of the increased income.
Timing
In some cases, you may decide that a Roth conversion is right for you, but not right now. This may be due to the effect on college financial aid or other financial assistance. Or, it may not be advisable with your current tax situation. There are all sorts of reasons that a Roth conversion might not be appropriate with your current tax situation. Remember that a Roth conversion will generally cause a higher adjusted gross income and taxable income. Factors to consider include higher than usual medical expenses which could be deductible in the absence of the income caused by a Roth conversion. Or perhaps you have higher than usual capital gains which could be taxed at a higher rate due to the higher taxable income. In cases like these, you can revisit the question in future years when your situation may be different.
Keep the big picture in mind
One last item to consider is the importance of looking beyond just current and future tax brackets. A Roth conversion could still be appropriate even if you are currently in a high bracket. As we said above, it isn’t only about income tax brackets. There are the considerations of other fees and costs. There are the constraints of current cash flow and taxes. Identify which factors are short term impacts and which are long term impacts and weigh them when evaluating your options.
Carefully consider the future costs and benefits as well. The Roth conversion would allow growth of the Roth account to escape future taxation. This could be beneficial if you expect to be in high tax brackets going forward as well. And, don’t forget to consider the impact of any inherited IRA or qualified retirement plan accounts. Those accounts may also have RMDs which could compound the tax difficulties associated with RMDs from your own accounts. Finally, it’s important to remember that we can only make decisions based on what we know today. We can be sure the tax code will change in the future. It is possible that tax regulations will make your Roth conversion less valuable in the future.
These are parts of the big picture but are often neglected when considering Roth conversions.
Seek help from qualified advisers
Roth conversions can make a big difference in your ability to meet your future cash flow needs. But, as you can see, there are many factors that go into determining if a Roth conversion is right for you and whether it’s right for you right now. A good financial planner or tax adviser can help you determine the factors that will likely affect you.
This article is intended to be educational and thought-provoking rather than financial, legal or tax advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.