The Roth IRA is a great retirement savings vehicle. It provides an option to avoid taxes upon withdrawal for those who have utilized one. However, given its relatively recent creation, some retirees did not have ample time to contribute to Roth IRAs or were above the income phaseouts to contribute. This has led to some who are stuck with large concentrations in tax-deferred assets like 401k’s/IRA’s and are staring down the barrel of large future tax bills. Tax-deferral is great, but paying the taxes is not, which rightfully begs the question of how to lower that impending bill. The popular option is to convert these pre-tax dollars into a Roth IRA, but contrary to what a lot of articles will tell you, this technique could make you worse off if your situation does not warrant it. The decision of whether to convert or not should be considered within your overall financial situation by assessing your goals, timeframe, liquidity, tax brackets and how the actual taxes are to be paid.
It may seem self-evident, but before considering a Roth conversion, your goals and financial situation need to be evaluated holistically. Roth conversions are a big commitment and can be expensive as taxes are owed in the year of conversion. In the context of your unique financial circumstances, no decisions are independent, so committing to one could affect other components of your financial plan. Continuing to defer taxes by keeping money in an IRA or paying taxes now to convert and save later will affect more than just the funds in your retirement accounts. Depending on when a conversion takes place, it could affect income adjustments for certain benefits like Medicare, taxability of Social Security, the amount your heirs receive, and if you’re not careful, liquidity within your portfolio. Being informed of how and to what degree your goals are affected by a conversion is the most fundamental step. No matter which route you choose, there will be tradeoffs. If after careful consideration it is determined that your situation may benefit from a conversion, then further analysis should be done to more accurately project the costs, benefits, and optimal timing.
Like all investments, the time horizon and risk tolerance are crucial considerations for a Roth conversion. By paying the taxes now and converting IRA assets into a Roth IRA your overall portfolio starts off at a lower dollar amount. Because of this, it takes time for the growth in the Roth account to recuperate the money lost to taxes. Ideally, this money is invested for growth and is not withdrawn for many years, which creates an opportunity to realize tax-free gains that exceed the taxes paid. Converting to a new Roth IRA begins a 5-year window where withdrawn earnings are not only taxed but incur a 10% penalty. Therefore, if at any point in time this money is needed to fund retirement expenses within the short to intermediate term, then a Roth conversion may not be worth it.
One of the lesser considered components of a Roth conversion is the “Pro-Rata Rule”. It requires a taxpayer to look at pre- and post-tax balances across ALL IRA accounts and determine what proportion of the conversion is a taxable event. IRAs are typically utilized for their tax deferral (pre-tax), but they can also be funded with after tax dollars, which is where the pro-rata rule comes in. If you were to fund an IRA with some after tax dollars, you cannot cherry pick which portion of the conversion is pre versus post tax. Even if a new IRA is created for the sole purpose of Roth conversions. For example, take an old IRA funded with $93,000 pre-tax, and a $7,000 contribution to a new IRA that was made after tax. This person wants to convert the $7,000 of after-tax IRA money to a Roth IRA. The IRS taxes the conversion proportionally by taking the ratio of after tax/pre-tax dollars across all IRAs. In this situation 93% of the conversion is taxable at the payor’s marginal tax rate.
An entire article could be written on taxes and how Roth conversions affect them, but tax brackets are typically one of the main drivers in conversations of whether to convert or not. It is important to note that the considerations are deeper than what your tax rate is now, and what it’s projected to be. But the general rule of thumb is if you anticipate your taxes to be higher during retirement, then a conversion could make sense. These large tax bills are typically seen when Required Minimum distributions kick in, and tax-deferred money is forced out of qualified accounts. But if you are working and in a high tax bracket now, then it may not make sense. Roth conversions are taxed as ordinary income at marginal tax rates, so they may bump you into even higher tax brackets. If you plan on converting large amounts of IRA assets, then be very mindful of your tax situation.
The source of funds to pay the taxes on the conversion of the tax-deferred assets themselves is an often-overlooked component of successfully converting. That is, can you pay the taxes out of pocket? The ideal scenario would be to have cash set aside to pay the taxes instead of realizing gains in a taxable account, or having taxes withheld from the pre-tax assets being converted. If the taxes paid are withheld from the conversion itself, it will take longer to recuperate the lost funds when comparing the Roth balance versus your IRA balance. Depending on your tax bracket, you could be starting with a Roth balance that is ~20% less than your IRA balance heading into retirement. Higher Roth balances to start with gives more to compound, which will see larger tax-free growth, and an earlier point at which you will come out ahead from converting.
You cannot evaluate the merit of Roth conversions without addressing your estate plan. Leaving money to heirs is a common goal that a Roth conversion could make more efficient. While inherited Roth IRAs are subject to RMD rules, this money will be tax-free. As opposed to an IRA where the distributions are taxed at ordinary income tax rates. Depending on the time horizon of the objective and the tax rates of whoever inherits the Roth it won’t always guarantee they come out ahead. If you have a short time horizon and heirs in lower marginal brackets, then there is a risk that dollar for dollar, a conversion could cause them to end up with less after paying taxes even if the Roth distributions are tax-free. In general, the time horizon should be sufficiently long, and the heirs should be in higher marginal brackets to make this strategy worth doing.
The concept of a Roth Conversion is appealing for most. Pay a little tax now, to convert to a Roth IRA and have future growth become tax-free. This technique certainly can lower future tax liability when funding retirement goals, or transferring assets to heirs, but given how popular of a talking point they have become, some look at their use cases with rose colored glasses. If your situation may be improved by converting, then there is merit in exploring a Roth conversion. It can be a great strategy, but not every situation warrants action. To really understand the effect that a Roth conversion would have on your goals, the taxability of your portfolio, time frame, and other underlying tax factors all need to be considered within the context of your overall financial situation when projecting forward. Otherwise, converting might make you or your heirs worse off in the long run. Being calculated and well informed in each of these areas will only lend itself to a better decision. Your advisors at Legacy Trust would be happy to help you consider whether a Roth conversion is right for you.
Collin Hartley,
Associate Wealth Advisor &
Wealth Planner