---- — A Roth IRA conversion is the process of transferring funds from an existing traditional IRA to a Roth IRA. The decision to convert presents an interesting quandary for investors.
When you convert to a Roth IRA you’ll be accelerating income taxes on the conversion amount in exchange for tax-free growth and the opportunity to avoid required minimum distributions upon reaching age 70½. This permits more of an investor’s wealth to grow tax-free and for a longer period of time.
It’s not an easy decision and clearly the Roth conversion is not for everyone. To make a smart choice investors need to clarify their financial goals, recognize the pros and cons of conversion and how they might impact their finances now and at retirement. To help reduce the complexity of the decision, let’s look at the three central considerations for determining if a Roth conversion is right for you.
1. Current vs. future tax brackets: Will you be in a higher tax bracket when you begin taking distributions than when you convert? Future taxes are an important factor in your decision, albeit a difficult one to determine with any degree of accuracy. All other things equal, if an investor expects to be in a higher tax bracket when making withdrawals, a Roth conversion could result in a larger after-tax portfolio than a traditional IRA because the advantage of a Roth’s tax-free growth and distributions will outweigh the cost of paying taxes now.
However, like most decisions in life, all other things are not equal, so making the decision to convert based solely on a guess about future tax payments would be unwise. A Roth offers two benefits over a traditional IRA that can make it advantageous to convert even if you expect tax rates to fall in your retirement years. First, depending upon what funds you use to pay the taxes, it can allow you to grow more wealth tax-free. Second distributions from Roth accounts are exempt from required minimum distributions and, therefore, offer a powerful vehicle for wealth accumulation for those expecting to let their accounts grow for a long time.
2. Source of funds to pay conversion taxes: Where will the money come from to pay income taxes on the amount converted? The source of these funds is important because if you pay the taxes from your traditional IRA or another retirement account you will lose the potential benefits of tax-free growth on that amount. Also, if you’re under 59½ you will likely incur a 10 percent federal penalty. Some states may also impose their own “early withdrawal” penalties. Conversely, using taxable (non-retirement assets) to pay the conversion taxes in effect allows an investor to increase the total amount of tax-sheltered assets they hold in an IRA. For example, suppose an individual is considering a conversion of a $10,000 traditional IRA. At a 25 percent tax rate, the individual’s share of the IRA is $7,500 while the government’s portion is $2,500. However by paying the $2,500 in taxes from a taxable investment account, the Roth IRA will end up with a $10,000 balance, 100 percent of which is now the individual’s share.
In effect the conversion from a traditional to a Roth, with the resulting taxes paid from a non-retirement account allowed the investor to shift $2,500 from a taxable account to a tax-free Roth. Another way to describe this is to say that dollars in a Roth IRA are worth more than dollars in a traditional IRA because once you have paid your taxes from outside funds and “bought out the government’s share,” the Roth gives you tax-advantaged growth on “more” wealth.
3. Investment time horizon: Unlike a traditional IRA, with a Roth you are not required to begin taking minimum distributions at age 70½ or anytime during your lifetime. This means you can keep the money growing tax-free for a very long time. The longer you leave your money in your account the more time it grows tax-free and, therefore, the greater the chance of recouping the taxes you paid on the amount converted. In other words, the further the individual is from needing to withdraw funds, the more likely it is that conversion is a good idea.
This ability to keep the Roth IRA growing tax-free without being required to take distributions also makes it an excellent estate planning tool, because you can leave the entire IRA balance to someone else. Then even after death the tax advantages of the Roth continue because the IRA continues to grow tax-free. Although your beneficiaries (except for spouses) will be required to take distributions over their lifetimes, those withdrawals will be income tax-free as long as some basic requirements are met. This can be especially valuable for those taxpayers who don’t spend all their assets during retirement and whose beneficiaries are in a high tax bracket. This ability to pass a tax-free lifetime earnings stream to young beneficiaries has tremendous wealth-building potential long after your death.
The decision to convert to a Roth IRA ultimately depends upon whether it results in greater after-tax wealth over an investor’s lifetime and, in some cases, beyond. The primary variables that drive the decision are current vs. future tax rates, the source of funds to pay the conversion taxes and the investment period over which the IRA is allowed to grow. Taxpayers’ job is not done, however, until they identify the secondary but still important interactions that the Roth conversion can have on their finances. We’ll discuss those next week.
John Spoto is the founder of Sentry Financial Planning, LLC in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com .
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.