When I was practicing as a financial planner, many of our new clients were recently retired IRA (individual retirement account) owners. And the number one question they had was whether or not to do Roth conversions from their traditional IRA. Or from their workplace retirement accounts, if they had most of their retirement savings there.
Generally speaking, these clients would want to do these Roth conversions as quickly as possible. But our job was to help them with their overall financial planning and tax planning.
So our goal was to help them build a Roth IRA conversion strategy that allowed them to minimize their federal income tax bill over their lifetime. By creating a long-term Roth conversion strategy, we could help manage their annual income level and their marginal tax rate.
Each year, as part of our tax planning appointment, we would review that year’s tax projection to make sure that our Roth conversion amount is in line with expectations. If there were unexpected changes, we’d factor those in and change our Roth conversions appropriately.
To Roth or Not to Roth?
The fact is, each person’s circumstances differ. The decision on whether to make Roth IRA conversions depends less on the numbers than on the account owners’ desires.
What might be a good idea in for a particular married couple might be a horrible strategy for another. Because there are so many factors that go into managing lifelong tax liability, it’s important that each taxpayer put some serious thought into their decision. And discuss those thoughts with their tax advisor.
With that said, here are some pros and cons of each decision.
Why you should do Roth conversions
If you’re inclined to make Roth conversions, here are some points that might support your argument.
Tax-free growth on any converted amount
Assuming that you can convert at a low tax bracket, you’ll never have to pay taxes again on a qualified distribution. And the investment growth from stock appreciation, dividends, capital gains. All tax-free.
And if you pass away before using the money in your Roth IRA accounts, your beneficiaries can benefit from tax-free withdrawals.
Avoiding required minimum distributions (RMDs)
According to the IRS RMD rules, IRA owners have to start taking required distributions beginning at age 72. From there, account owners are expect to withdraw a certain minimum portion of their account until they die or the account is empty.
This is a major pet peeve for many retirees. Imagine spending your entire life saving money in a tax-deferred account. Then, you’re in your golden years, and you’ve accumulated more money than you could hope to spend. But the United States government tells you that you have to withdraw the money and pay taxes on it anyway.
You don’t have to do this with any money in a Roth IRA. As long as the original account owner is still alive, all the money can stay in a Roth account.
Hedge against higher future tax rates
You might pay taxes now on Roth conversions at your current tax rate. This is a bet against the chances that you’d pay higher taxes down the road. And this might (or might not) be true.
If you’re in the camp that believes the federal government has no choice but to raise future taxes, then you may start doing Roth conversions now so you pay less tax later on. That might help you down the road in case there are higher tax rates in future years.
Let’s take a look at some of the arguments against Roth conversions.
Why you might not want to do Roth conversions
Of course, there are some reasons you wouldn’t want to do Roth conversions.
You’re simply in a higher tax bracket than makes sense.
If you’re going to do Roth conversions, you want to make sure you don’t pay too much tax. After all, it doesn’t make sense to do Roth conversions at the 37% tax rate if your eventual required distributions might only be taxed at 22%.
Perhaps you never have a chance to do Roth conversions because your income is always too high. Or perhaps you think that your beneficiaries are in a lower tax bracket and will pay less in taxes.
You’re interested in charitable distributions
Roth conversions can be a great opportunity to save tax dollars by paying income taxes at a lower effective tax rate. But do you know what’s even better?
Not spending any tax money at on Roth conversions or IRA withdrawals. And how could you do that? By doing qualified charitable distributions (QCDs).
QCDs are the most tax-advantaged way to contribute to charity. First, you’ve accumulated pre-tax money into an IRA. Then, your earnings are tax-deferred. Finally, your withdrawals don’t get taxed at all.
The downside is that the money has to go to a qualified charity (and not in your pocket). But if you are charitably inclined, it doesn’t get any better than that.
So why do Roth conversions on money that you had already intended for charity?
You might be in a lower income tax bracket in the future
Perhaps you’ve already made your money. Most of your retirement income now comes from capital gains, qualified dividends, and Social Security benefits.
And if you have relatively small balances in your retirement funds, perhaps the RMDs won’t kill you. Or the work involved in establishing a Roth conversion plan just isn’t worthwhile.
Consideration factors for YOUR Roth conversion decision
More likely than not, your situation is less of a “either-or” decision, and more of a “how much, and over what period of time” decision. More like a long-term plan with a timeline.
A timeline that YOU control.
If that’s the case, then perhaps you would think of factors that might help inform your Roth conversion strategy. While each account owner’s situation depends on unique and specific circumstances, here are seven factors that we’ve often discussed with clients.
You should take them into consideration when deciding whether or not to do Roth conversions for your retirement accounts.
For most people, it doesn’t make sense to do all of your Roth conversions in one year. Doing this would send your adjusted gross income (AGI) through the roof. And if you’re on Medicare, that will likely trigger IRMAA (Income-Related Monthly Adjustment Amount) and have an effect on your Medicare Part B premiums. Managing your Roth conversions is a good way to keep your Medicare premiums lower and minimize your IRMAA.
For most people, a reasonable timeline is between retirement and when you reach age 72, when you have to start taking RMDs. Even after reaching 72, you can still do Roth conversions. You simply have to take your RMD as well as the Roth conversion.
If you retire in your late 50s or early 60s, you’re simply going to have more time to make Roth conversions at a lower tax bracket and manage your taxable income than if you retire later on.
2. Account balances
This is pretty simple. The more money you have in your traditional IRAs and pretax workplace retirement plans (like 401ks, 403bs, SIMPLE IRAs, and 457 plans), the more difficult it will be to convert everything at a desirable tax bracket.
And the higher your balances, the more important it is to have a deliberate plan in place to do execute your Roth conversions each year. If you’re reviewing your Roth conversions with a financial advisor, ensure they take all retirement plan accounts into consideration as part of your tax planning.
3. Tax bracket
Your tax advisor’s goal is to help clients convert as much as possible at a desirable tax bracket.
Depending on your tax situation, a desirable tax bracket might be as low as 12%, or as high as 32%. For some IRA owners, a Roth conversion plan allows them to convert all of their IRA and 401k amounts into a Roth IRA at the 12% tax bracket.
For others, they might have to settle for paying taxes at a 32% in order to avoid paying taxes at 35% or 37% (or higher) down the road.
Here’s a hypothetical client example:
John & Jane have about $2 million in IRA assets. Since they’re both 60, they have 12 years to convert as much as possible before having to take required minimum distributions (RMDs).
Based upon other sources of income, their investment advisor tells them that they can convert these amounts at the following tax brackets before they reach age 72:
- 12%: $70,000 per year (or $840,000 total). In other words, if they stayed at the 12% tax bracket, they’d be able to convert $70,000 per year, for a total of $840,000. This is a conservative estimate, and doesn’t account for annual increases in the marginal tax bracket.
- 22%: $160,000 per year (or $1.92 million total)
- 24%: 100% of their account balances
An astute financial planner would present this, and say something like,” Based on this analysis, which tax bracket would you feel most comfortable with?” Then let John and Jane pick the tax bracket they want to optimize for. This gives them control over their Roth conversion strategy and makes them active participants.
Of course, this estimate doesn’t account for investment growth. Which is why John & Jane would be best served by reviewing their Roth conversion every year with their financial planner. That way, they can make adjustments each year to account for those changes.
4. Social Security planning
Another consideration for Roth conversions is future sources of income, like Social Security. We’ll cover the other future income sources in the next section. However, Social Security deserves special consideration, simply because it’s one of the biggest retirement decisions you’ll make.
Most people retire with the assumption that they won’t make that much after leaving their salaried job. This might be true for some people. However, many folks are (pleasantly) surprised when they find their retirement income to be higher than it was before.
Part of this is simply from the compounding effect of their savings and investments. However, a large part of this comes from future sources of income that they never counted on. Like Social Security.
You might read a lot about the Social Security Administration running out of money, It’s easy to forget that there is actual Social Security income that is paid out. So far, the Social Security Administration has not missed a payment to an eligible person.
While Social Security income is tax-preferred (not all of it is taxed), it is income that you should incorporate into your Roth conversion planning.
The earlier you take Social Security, the less room you have to make Roth conversions within your desired tax bracket. If cash flow is not an issue for you in retirement, this is another consideration for delaying Social Security benefits.
With Social Security income, you either have to convert less from your IRA to stay within your desired tax bracket or be willing to accept moving into a higher tax bracket.
5. Other sources of future income
While Social Security is the most common future income source for retirees, it’s not the only source of income. Many people might have:
- Inherited IRA distributions
- Income from inherited assets
- Deferred compensation
- Stock options
- Executive compensation and payouts
Each of these items can impact your Roth conversion strategy. Not only that, but there might be individual decisions that you’ll need to make to optimize your financial planning.
For example, a pension might come with a decision on when to take it, and which type of survivor benefit option to choose. Your financial advisor should be available to help decide when to take that pension and what option.
While supporting the Roth conversion strategy might be a consideration, there are other factors that might be best for your overall financial planning needs, but not for the Roth conversion strategy.
But once that decision is made, you should incorporate that into your Roth conversion strategy. What you don’t want to do is let the tail wag the dog. In other words, don’t make a bad pension decision just to support the Roth conversion strategy.
6. Estate planning
As a result of the SECURE Act (Setting Every Community Up For Retirement Enhancement Act), inherited IRAs must be fully distributed within 10 years.
You should look at who stands to inherit your IRAs so you can tax impact this might have on your beneficiaries. Some people might have beneficiaries in a lower tax bracket. For them, inheriting a balance wouldn’t cause a huge concern because they’re paying a lower tax rate.
Conversely, some people might want to ensure their IRAs are fully converted because their children are high earners. Inheriting huge balances could force them to pay at a higher rate than you would have.
7. Charitable contributions
As previously mentioned, if you’re charitably inclined, you might decide that fully converting IRAs into a Roth account would not make sense. Each person is able to contribute up to $100,000 per year from their IRAs as a qualified charitable distribution.
This means that the money a person saves in their IRA and is eventually given to charity:
- Was contributed to the account without taxes
- Has been growing without taxes, and
- Will have been given to charity without taxes
So your financial advisor should help you create your charitable contribution plan that complements your Roth conversion strategy. And helps you manage your tax bill.
For many people, it doesn’t make sense to contribute to Roth IRAs while they are still working. However, when retirement comes, this is a question that easily comes to the top of their mind.
While it’s simple to think about what a Roth conversion strategy might look like, it becomes a little more difficult when you actually sit down to create the plan. And it’s even more difficult to keep on top of the plan year after year. But a tax professional or a tax-focused financial advisor should be able to help you with your Roth conversion strategy.