Roth Conversions - Should You Take the Plunge?

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One of the most frequently asked questions we get as professionals is whether to convert a traditional IRA to a Roth IRA.  Without constructing one of the most elaborate decision trees you’ve ever seen – I’m not kidding, here – there are some general principles to consider before deciding on such a course of action, which should be done with considerable care. 

For instance, a high-earning couple with an IRA worth $500,000 could be required to pony up close to $200,000 in taxes upon withdrawals if they are in the 40% marginal tax bracket (federal and state combined).  In deciding to pursue a conversion, the primary variables include:

  • Future estimate of tax rates versus today, and what tax bracket you may be in
  • Your financial prospects (will you need this money to fund your lifestyle?)
  • Your time horizon – your age and likely longevity

In many cases, there are so many variables to weigh that you’d be better off flipping a coin.  But for some, it’s a no-brainer.  The focus of this piece will address when investors should recognize if they are in this advantageous situation. 

Let’s start by evaluating the circumstances enjoyed by my favorite fictional clients, George and Mary Petersen.  This couple is in their late-50s and plans to retire in a few years, since they live a modest lifestyle and have accumulated $2,500,000 in investable assets (of which $500,000 is in an IRA).  Here are multiple reasons why they should consider a Roth IRA conversion:

They are happy to incur a tax liability today versus later.  They believe tax rates will rise in general due to expanding government deficits.  They both cut back to a part-time schedule this year after relocating to Miami, so they expect to be in a lower federal tax bracket and Florida does not levy income taxes.  However, they expect to be in a higher tax bracket in their 70s due to (1) the expected growth in their investment portfolio along with a sizable inheritance, (2) social security income, (3) pension income, and (4) plans to return to higher tax state in the back half of their retirement. 

There are no lifetime required minimum withdrawals (RMDs) associated with Roth IRAs.  This is ideal since they do not plan to consume all their wealth and can avoid paying ordinary income taxes on money they do not need after turning 70 ½, as with a traditional IRA.  Because they are in great health and expect to live into their 90s, they most likely would be forced to empty most of their IRAs under the prevailing scenario, which would push their income into an even higher tax bracket.

They plan to leave an estate.  Because they are confident they won’t consume their entire wealth and have family members they’d like to leave a legacy for, their children and grandchildren can receive tax-free distributions and can stretch payouts over their longer life expectancies. 

They have access to funds to pay taxes.  Because they have a sizeable checking account, there is ample cash to pay taxes on conversion.  Importantly, this move will also reduce the size of their estate subject to future estate taxes.

They value tax diversification.  Because they expect some years with higher cash outflows – for a vacation home or foreign travel – they have the flexibility to pull money out tax free to avoid being “tripped” into a higher tax bracket.

The market has just experienced a correction.  They know it’s a good time to do a conversion since their income tax liability is lower than it would have been otherwise, given lower valuations in general.

They plan to defer claiming social security until 70.  Because they value the 8% bump in income that social security offers for each year of deferral, they plan to execute a series of Roth IRA conversions rather than do everything in one fell swoop.  In the first several years of retirement in their 60s, they will have only a small pension (since they are deferring social security and RMDs aren’t required until 70 ½), so they will be in a very low tax bracket.  Because Roth IRA conversion amounts are considered income and taxed at ordinary income tax levels, they will convert only as much as needed to bring their total income up to $75,000, where they would remain in the 15% bracket.  If they were to do a conversion while working or after 70 ½, they would surely be in a higher tax bracket.  They understand those who have recently retired are in an advantageous situation to create income to make ends meet while also reducing their future tax burden.

In short, if you should find yourself in a low-tax bracket year and expect much higher income in future years, consider pursuing a Roth IRA conversion and have a discussion with your Wealthcare360™ advisor at The Johnston Group.  For many people, this typically occurs between the ages of 60 to 70 after retiring, but before they begin taking RMDs and social security.

David WebbMike Giefer