To Roth or Not to Roth?

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.

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.

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.