As we head into end-of-year tax planning, it seems that one question is on everyone’s mind: Should I convert my Traditional IRA to a ROTH IRA? Articles are everywhere touting the value of ROTH conversions, and for good reason. ROTH IRAs offer many potential benefits, including tax-free growth, tax-free withdrawals (when adhering to qualified distribution criteria), no minimum withdrawal requirements at 70 1/2 and the ability to pass on the assets to heirs tax free. And while income thresholds generally take ROTHs off the table as an option for higher income earners, a ROTH conversion has no income-based requirements, making it a valuable tool for bringing the benefits of a ROTH into the retirement landscape.
But while converting a Traditional or Rollover IRA to a ROTH IRA can be advantageous in many cases, the choice isn’t always as clear-cut as it sounds. Here’s an example:
Joe and Sally, both age 68 and recent retirees, were each planning to convert $30,000 from their individual Rollover IRAs to a ROTH IRA this year. Their goal: to continue deferring taxes while reducing the required minimum distribution they would have to withdraw when they hit 70 1/2. Generally, ROTHs don’t have minimum distribution requirements (the exception is with inherited accounts), so the thinking was that a ROTH would help them save on taxes in their later retirement years when their income and expected tax bracket would be lower than it is today. It would also give them more flexibility about when and how they want to spend down their assets. Plus, they don’t really need the money now since the Social Security benefits and pensions they’re receiving today are sufficient to cover the majority of their expenses.
At first glance, it seemed like a great plan, but when we looked at the details, we found that converting $60,000 this year would be a mistake. First, income from Joe and Sally’s Social Security benefits and pension is subject to ordinary income tax treatment, so despite their status as retirees, adding an additional $60,000 in taxable income this year would push them into a higher tax bracket. Second, the two $30,000 conversions would also cause their Social Security benefits to be taxed at a higher level. Clearly, a ROTH conversion isn’t the best option for Joe and Sally.
Of course, that doesn’t mean a conversion isn’t right for you, but it’s important to look at every detail of your situation before making the leap. Here are the primary factors that should drive your decision:
- Your tax bracket. Contributions to a ROTH IRA are not tax-deductible, but earnings grow tax deferred and qualified withdrawals are tax-free and penalty-free. Contributions to Traditional/Rollover IRAs are tax deductible, earnings grow tax-deferred and withdrawals are taxed as current income. The goal is to leverage the vehicle that does the best job at minimizing your taxes. In many situations, paying the taxes associated with a ROTH conversion in pre-retirement years is the best move. For others, it makes more sense to keep assets where they are and forego a conversion completely. (Talk with your advisor to determine the best approach for you.)
- When you need your assets. After age 70 1/2, withdrawals from Traditional and Rollover IRAs are mandatory, so you’re forced to draw down your assets — and pay taxes on that income — whether you need the income or not. In contrast, ROTH IRAs are not subject to minimum distribution requirements, qualified withdrawals are tax-free and your assets can be passed on to your heirs tax-free.
- Tax rates and the stock market. Today’s tax rates are at historic lows. Since that means tax rates are almost certain to rise in the future, now may be an ideal time to make the move to a ROTH IRA. Yes, you’ll have to pay taxes on the assets you move from the Traditional or Rollover IRA, but those taxes will most likely be lower now than in the future. At the same time, if your Traditional IRA account has fallen in value in recent weeks (and whose hasn’t), the decreased value could result in a lower tax bill now if you choose to convert to a ROTH.
When deciding if converting to a ROTH makes sense for you, don’t let the media sway you one way or the other. Consider your specific circumstances and look at your financial ‘big picture,’ including all current and future sources and amounts of income, as well as your tax situation and overall objectives.
Need help deciding if a ROTH conversion is right for you? Talk with your tax advisor, or give us a call. We’re always here to help.
A note about ‘backdoor’ ROTH contributions. Most utilized by high income individuals, a ‘backdoor’ contribution occurs when money that has been used for making a non-deductible contribution to a Traditional IRA is later converted to a ROTH IRA. This strategy works best if you don’t have other Traditional IRA assets. IRS regulations regarding these conversions are complex and, in many cases, could become problematic. Most investors would likely do better to pay the taxes that would result from converting a portion of their assets from a Traditional IRA outright to a ROTH.