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To Roth or Not to Roth?

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Learn why it may be an advantageous time to convert your retirement savings to a Roth IRA.

Given historically low income tax rates, proposed tax policy changes, and the ability to reduce taxes paid on conversion with a corresponding charitable deduction, now may be an opportune time to consider a Roth conversion.

The decision to convert to a Roth IRA is rife with complexity and should be made in alignment with your personal financial goals and in close coordination with your advisors. There are many factors to consider, such as whether your effective tax rate is likely to be higher in the future, if you will need to rely on Roth assets to support lifestyle spending needs in retirement, and if you have sufficient liquidity to pay the income tax due upon conversion.

Even for investors in the top federal tax bracket, converting to a Roth and paying the associated taxes at current rates may have compounding benefits, such as:

  • Locking in current income tax rates if you expect future rates will be higher. Such expectation could be based on an assessment that currently proposed legislation will become law. Alternatively, it might be because you plan to move from a state that does not tax conversions or that imposes tax at very low rates to a state that taxes Roth conversions at higher rates.
  • Qualified Roth IRA distributions are not subject to income tax. By contrast, earnings on all traditional IRA contributions will be taxed at ordinary income tax rates, and only the value of non-deductible or after-tax contributions will be exempt from taxation. In other words, once converted, IRA assets no longer grow on a tax-deferred basis, they grow tax-free.
  • Tax diversification, flexibility to manage tax brackets, tax-free withdrawals, and no required minimum distributions during the life of the IRA owner.

Although you will be required to pay income tax on the Roth IRA conversion amount, a conversion may be advantageous if you believe you will be in a higher tax bracket when you make future withdrawals. Such tax planning strategies become even more valuable should legislative proposals to increase the top income tax rate and offset income deductions become a reality.

In addition to tax rates, your time horizon is an important factor to consider before implementing a conversion. In the analysis below, it would take nearly 20 years for a 55-year-old to break even. Nevertheless, all else being equal, an older individual will realize the benefits of a conversion quicker since they are able to avoid required minimum distributions sooner (at age 72, when required minimum distributions kick in for traditional IRAs). If the older account holder intends to designate a relative or another individual as beneficiary, their time horizon will be extended for that period, when those beneficiaries receive distributions. Beneficiaries of Roth accounts now have a 10-year payout period following the death of the account owner, except for eligible designated beneficiaries1.

Increased Net Proceeds with Roth Conversion

Comparing after-tax proceeds after 40 years assuming a constant tax rate of 37%:

Reduce Risk Through Tax Diversification

A Roth conversion allows you to diversify exposure to income taxes rates. You can achieve tax diversification by maintaining a mix of taxable, tax deferred (401(k)/IRA) and tax-exempt accounts (Roth 401(k)/Roth IRA) with varying rules for taxation and withdrawals. Tax diversification reduces the range of possible after-tax outcomes by mixing strategies that presume tax rates will go up with those that presume they will go down. Pairing tax diversification with a mix of asset types will also enable more effective tax planning. Additionally, distributions are required from traditional IRAs starting at age 72, whereas Roth IRAs do not require distributions. A retiree who owns both traditional and Roth IRAs may be able to minimize income taxes by coordinating their mandatory taxable withdrawals with their discretionary tax-free withdrawals.

Why Convert Now?

There are several factors that make a Roth IRA conversion more attractive than ever2, including:

  • Recent legislation provided a temporary enhanced deduction to mitigate tax exposure of a Roth conversion. For 2021, the CARES Act suspends the adjusted gross income (AGI) limitation for charitable cash contributions. Under this temporary rule, individual taxpayers may deduct up to 100% of AGI for cash contributions to public charities (contributions to donor advised funds and private foundations do not qualify). Retirement account owners may be able to effectively create an income tax-free 2021 Roth IRA conversion by pairing the conversion with cash gifts to public charities.
  • Roth conversions are a target of tax reform. Under current tax proposals, the ability to convert to a Roth is eliminated for single taxpayers with income over $400,000 in 2032.
  • Historically low income tax rates and many of the current tax proposals kick in at certain brackets, making tax-diversification more attractive to smooth income.
  • The SECURE Act of 2019 eliminated the ability of most beneficiaries to “stretch” distributions over the beneficiaries’ life expectancy. The prior law’s grant of lengthy distribution deferral for inherited IRAs (allowing the beneficiary to withdraw the funds over many years, often decades) greatly reduced the likelihood of a Roth conversion, yielding superior after-tax returns. Now that certain beneficiaries must withdraw within a 10-year payout from any inherited IRA, it is more likely that an earlier Roth conversion will save taxes, overall. Notably, the IRA owner’s adult children who are neither disabled nor chronically ill are among the beneficiaries subject to the 10-year payout under the new rules.
  • Estate taxes are here to stay, and the taxes paid on conversion are excluded from your taxable estate.

It Is Not All or Nothing — But It Is Permanent

There are different strategies to consider when weighing the benefits of a Roth conversion, such as a partial conversion of your retirement account. The tax impact of a smaller, partial conversion will be easier to mitigate. If your overall taxable income is lower in a given year, being in a lower tax bracket offers an even more valuable opportunity to complete a partial conversion, pay less tax on the conversion and diversify the types of accounts owned with different tax treatment. There may also be opportunities to take advantage of dips in the market to convert assets at a lower value.

An analysis of facts and circumstances is always required to determine if a Roth conversion makes sense for your unique situation. But beware: Once your IRA is converted to a Roth, you will not be able to turn it back into a traditional IRA. If you think a Roth conversion might benefit you, consult with an experienced advisor now. This may afford you enough time to weigh all the relevant factors and — if you decide to convert to a Roth IRA — complete the transaction before year-end.

Multigenerational Families

Roth IRAs

Should you convert now?

THE NORTHERN TRUST INSTITUTE

Proven Advice for Moments that Matter

  1. An “eligible designated beneficiary” describes a category of IRA beneficiaries entitled to withdraw the account over their remaining life expectancies. This rule applies to an account for the sole benefit of the IRA owner’s surviving spouse, as well as to several less common scenarios, such as an account benefitting a special needs trusts for a permanently disabled person.
  2. This does not mean that all current factors favor a Roth conversion. For example, it is better to convert when asset values are low but expected to rebound in the near future, such as right after a market correction. Importantly, individual circumstances may exert pressure in opposition to the commonly shared factors described in this article.

Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

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