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Roth Conversions | Rules & Strategies

It’s difficult to talk about retirement accounts without mentioning taxes. When you start saving for retirement, you also need to consider the tax treatments on those accounts.

One of the most common tax-advantaged retirement accounts is the Roth IRA. These can be a great way to save if your tax rate in retirement will be similar or higher than your current tax rate. You don’t get a tax deduction when you contribute, but your withdrawals in retirement are tax free (though you should keep in mind that if you’re already in the 24% or higher federal tax bracket, you probably can’t – and probably shouldn’t – contribute to a Roth). In addition, Roth IRAs generally mean your investments grow tax free and there are no required minimum distributions (RMDs) associated with them. And last, but not least, another perk for a Roth IRA is the potential to use it as an estate-planning tool. You can leave Roth IRA accounts to beneficiaries who can benefit from the tax-free income, which can be stretched over their lifetime.

Roth Conversions

Because of these potential tax advantages, a common tax management question that can arise is: should you convert a traditional IRA to a Roth IRA? If you anticipate being in a higher tax bracket in retirement, a Roth conversion may be something to investigate further.

On the surface, a Roth might appear superior since its tax-exempt nature amplifies compounding investment returns over time. It’s not quite this simple, however – several criteria must be met in order for a Roth conversion to make sense.

Roth Conversion Criteria to Consider

The most important factor to consider when it comes to Roth conversions is future tax rates. Remember, Roth IRAs are funded entirely with after-tax dollars – only growth and withdrawals are tax exempt – so when you convert to Roth, you pay ordinary income tax on every investment converted. So if your future tax rate in retirement will likely be lower, as it often is, then converting and paying taxes now, as opposed to later, might not make sense.

Another factor to consider is that a Roth conversion could generate a hefty tax bill since a Roth enjoys tax-exempt growth, which means a greater benefit is realized over time with a higher initial balance. But a lot of this benefit is erased if you pay taxes out of your IRA balance, so a Roth conversion is more impactful if you can pay the tax bill with an outside, non-retirement account.

In some cases, you might be able to fine tune your tax planning by converting a portion of your 401k to a Roth IRA. Check with your employer to see if this is a possibility.

Our Take

If you expect your future tax rate to be higher, are able to pay the tax bill with non-retirement assets, and you have a long time horizon, then a Roth conversion might make sense for you. It’s always a good idea, however, to consult with tax and investment professionals before you decide to convert.

For more information on Roth conversions as well as how other tax-related topics fit into your larger financial picture, download our free Personal Capital Tax Guide for Holistic Financial Planning.

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This blog is for informational purposes only; we are not in the business of providing tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.

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