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.