'Tis the season to consider a Roth IRA conversion.
If you own a retirement account that you funded with pre-tax contributions, such as a Traditional IRA or a 401(k), those accounts are growing on a tax-deferred basis. You avoid paying taxes today, but will pay taxes in retirement as you take withdrawals.
Alternatively, what if you could have those savings grow tax-free?
Roth IRA conversion explained: This is what a Roth IRA conversion accomplishes. You elect to reclassify some-or-all of your tax-deferred IRA savings into Roth IRA savings. Those funds will begin to grow tax-free, forever. There is a trade-off though. You must recognize whatever amount you convert as income in your current year's tax return. This means a potentially big, one-time tax bill today.
All in favor: Roth IRA advocates will argue that it is better to have your money grow tax-free than tax-delayed. Seems logical, right? If you are 10 or 20 years from retiring, that is a long time to reap future earnings. It is hard to lobby for the tax later characteristic of a Traditional IRA or 401(k) given the tax never opportunity of a Roth IRA.
With Roth IRA conversions specifically, a popular question to ask is: Do you think tax rates will be higher or lower when you retire? This is a rhetorical, loaded question that many advisers will ask. It insinuates that tax rates will assuredly be higher in retirement, and so you might as well pay taxes today rather than at a higher rate in the future. Despite having no way to prove that, it sounds compelling because it tugs on our collective distrust of government and our disdain for the tax man.
All opposed: Roth IRA skeptics will argue that it is important to take advantage of tax-deferral now, while your tax rate is peaking during your working years. They will say to wait until your tax rate falls in retirement - when you presumably have less income coming in - and then start taking withdrawals when you are in that lower tax bracket.
The truth: Either argument can be right. It just depends on your situation and the assumptions used relating to your financial future and tax rates. Nonetheless, if you have a $100,000 Traditional IRA, what do you do? Here are a few rules-of-thumb we use with clients...
- The younger you are, the longer you stand to benefit from the tax-free growth that a Roth IRA provides.
- If your income is abnormally high in any given year, refrain from doing a Roth IRA conversion, as the converted amount might kick you into an even higher tax bracket.
- If your income is abnormally low in any given year, you might execute a Roth IRA conversion to make use of the lower, more generous tax rate.
- Before you pull the trigger, make sure you have ample cash available to pay the tax bill. If you converted $100,000 in this example and land in the 33% income tax bracket, you will need $33,000 available to pay taxes.
These are a few general guidelines. Now let's look at a few specific situations we have encountered with clients...
Life at 70: Do you foresee taking regular IRA withdrawals in your 70s? Or will you predominantly live off of other income? Tax-deferred IRA and 401(k) accounts are subject to Required Minimum Distribution (RMD) laws, which kick in the year you turn 70.5 years old. The IRS forces you to withdraw a certain amount each year, which is based on your age and calculated as a fraction of your total IRA/401k balance. This is government's way of collecting tax revenues from you that they have spent decades waiting to receive.
Roth IRAs, meanwhile, are not subject to RMDs. This means you never have to worry about how much you take out year-to-year when you turn 70. The notion of having to take withdrawals on your own money may sound like a first-world problem that you will gladly confront down the road, but you may not want to touch your savings at that point if you have other sources of income. With a Roth IRA you never worry about that.
What about the kids? Along these same lines, if you desire to leave behind a certain amount to your heirs, RMDs can disrupt that. As money comes out and is taxed, the tax-deferral benefits slowly fade. Also, RMDs do not disappear when you die. Whoever inherits your tax-deferred savings must continue taking minimum amounts each year.
RMDs do kick in on Roth IRAs after the owner's death. However, because no taxes are owed the impact is muted when heirs take those distributions.
Sort-of retired? The years leading up to retirement, or just barely into retirement, may provide a sweet-spot for timing a Roth IRA conversion. For example, your income could be really low if you are not receiving a paycheck and have yet to begin receiving certain benefits like Social Security or pension payments. You may squirm, understandably, at the notion of paying taxes on a six-figure (or seven-figure) IRA balance all at once. So, instead of converting a massive balance all in one year, spread it out and do multiple, smaller Roth IRA conversions over a series of years. This will help suppress your tax rate.
You want to make contributions: While anyone can do a Roth IRA conversion on whatever amount they wish, you cannot make annual Roth IRA contributions if you earn too much money (for 2018, income above $135,000 if single or $199,000 if married). If you plan to contribute any amount up to the annual cap of $5,500, first make sure that your income qualifies you.
This makes the distinction between a Roth IRA contribution and a conversion an important one. Suppose your income is rising quickly year-to-year. While you may qualify to make Roth contributions today, you may not be able to for long. As a result, it might not make sense to do a Roth IRA conversion if you won't be able to contribute to it in the future. Financial planning is about skating to where the puck is going to be, not where it is now.
Why do a Roth IRA conversion right now? The end of the year is ideal because you should know where your income will end up for the year. It is easier to estimate your tax rate and overall tax burden in December than it is in February.
There are a number of factors that can sway your Roth IRA decision. Use these to get the ball rolling and to start planning ahead in the event this is something that will benefit you in the coming years.
- Brian E Betz, CFP®