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Considerations for Roth Conversions

Roth conversions have become an increasingly popular topic over the years. As investors have experienced multiple bull markets resulting in compound returns and an everchanging tax landscape, many are looking for vehicles providing tax-free opportunities. Couple that tax-free growth and distributions (for those over age 59 ½) with earlier access to the basis within your account and it’s no wonder why Roth IRAs have become such an important planning tool.

How does one determine if “now” is the right time for conversions? Below are a just a few considerations to get you started:

How do you expect your current income tax rates to compare to rates in retirement?

Current vs. future taxes is the debate that drives the entire conversation surrounding pre-tax and Roth savings. Unfortunately, that elusive crystal ball is required to know exactly what the future will hold; and which will ultimately be best. However, there are a few broader components that can help point you in one direction or the other.

  • Overall outlook on tax rates/policy: this is typically the foundation for deciding between contributing pre-tax or Roth in the current sense. To keep it simple, if you expect future tax rates in general to be lower, saving on a pre-tax basis and paying the taxes later could make sense. On the other hand, if you expect future tax rates to be higher, saving via Roth with tax-free future distributions could make sense. This same line of thinking can apply to Roth conversions as well. For a specific example, consider the current situation of the Tax Cuts and Jobs Act set to expire at the end of 2025. If that happens, income bracket thresholds are expected to lower with corresponding rates reverting to the higher percentages. Because of this, some individuals may choose to convert pre-tax dollars now to take advantage of the current rates before the potential sunset.
  • Broader lifestyle expectations: all things being equal, if you have the same income with the same tax bracket in retirement as you do while working, the pre-tax vs. Roth debate becomes a bit of a wash. But, if you are expecting a major shift in your income/lifestyle (higher or lower) between now and later in retirement, that can have a large impact on the decision to convert or not. Like the point above, it boils down to your expected tax rate now compared to that of the future. In this case, the focus is placed on current income and future distribution needs instead of Federal/state tax policies. For instance, if you happen to be in your peak earnings years late in your career and expect to live off a fraction of what you currently make in retirement, now may not be the best time to convert assets. Again, the line of thinking goes back to the expectation that higher current income = higher current taxes and lower future distributions = lower anticipated future taxes.
  • Required Minimum Distribution projections: for those of you with a financial plan that includes cash flow projections, something you can look at is your future RMD expectations. It’s not uncommon for retirees to encounter years where their RMDs end up being greater than what they need to meet their expenses. Psychologically, this feels as though you are paying unnecessary taxes on excess income in those years. Roth conversion can help toward a possible solution. Not factoring in the items above, converting larger amounts early on (increasing future tax-free sources) to reduce future excess RMDs is a compelling argument.

Has there been a major market pullback?

Separate from the current vs. future tax expectation, performance within your accounts may also create opportunities for Roth conversions. The ideal time to convert assets would be when income and taxes are lowest. However, looking solely at that ignores the impact of future investment growth.

Although nobody wants to see a pullback in their investments, that could present an opportunity to accelerate some taxes within an account. For example, let’s assume someone’s IRA happens to be down -25% in a given year. At that point, if they have a strong conviction that those investments will rebound over time, every dollar converted at that time could result in the entire rebound occurring tax free. In theory, they could have paid taxes on only 75% of the future account balance at breakeven by doing Roth conversions at a low point in performance.

Do you have necessary flexibility to cover the taxes?

We certainly can’t ignore that conversions costs money. What I mean by this is that there is no withholding, like taxes in your paycheck. Instead, the entire amount you convert ends up being included as taxable income, netting against your overall taxes when you file at the end of the year. If you previously expected a large refund or happen to have additional tax deductions, then this may not be as much of an issue. But, if you usually come close to breakeven on taxes, be prepared to pay the additional tax hit out-of-pocket, especially if you are converting a large amount. This is why I’d suggest prioritizing how flexible current cash flow/savings is before getting ahead of yourself and diving too deep into the items above.

It goes without saying that there is no one-size-fits-all solution when it comes to Roth conversions. Further, there is even talk about income restrictions and other potential changes in future tax law. While these are just a few items to think about, hopefully this at least helps spark the conversation if you haven’t had it already. As always, you should consult with your advisor and accountant before making any final decisions.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion.  These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.  In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.