When Does a Roth IRA Change Move Right?
During any given year, you will see many articles about Roth IRAs and the wisdom of converting your traditional IRA account into a Roth IRA.
The truth is that like almost any decision in the world of financial planning, the decision as to whether or not to convert to a
Roth IRA makes sense for the individual situation will depend on their unique situation.
Here are some factors that financial advisors and their clients should consider.
Current vs Future Taxes
The decision on whether to convert part or all of a client’s traditional IRA account to a Roth comes down to looking at
their current tax bracket versus where they might be down the road. Saying another way does it make sense to pay more taxes now to save on taxes later?
A key consideration in determining whether a Roth conversion is right for a client is whether they have cash outside of their IRA account to cover taxes.
It is seldom if it makes sense to pay taxes from an IRA as this will either lead to larger withdrawals than desired or result in the client taking less than they intended.
This could easily become a very expensive proposition subject to additional taxes.
(For more, see: Simple Maths Roth Conversion Math.)
Tax Bracket During Retirement
When IRAs first came to mind, retirees would definitely be in a lower tax bracket upon retirement,
and income taxes as withdrawals from their accounts would be made. with them in lower tax brackets than in their working years.
Retirees today can’t count on being in the lower tax bracket on retirement. Pensions and retirement account withdrawals can add up.
With many retirees also working in retirement their income can remain high. In addition, what is not known is the level of income tax headed.
If they lead drastically, even clients whose incomes drop in retirement could be hit by an increase in tax rates.
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Land Tax Considerations
Roth IRAs are not subject to the required minimum distribution (RMD minimum) and therefore remain intact and continue to grow in value.
After a client’s death, the account can go to a spouse who can create it themselves and is not charged RMD while they are alive.
The spouse in turn may leave the account to a designated beneficiary who will be required to collect the RMD but this distribution is not taxed.
The question here is does it make sense to convert to a Roth account now, pay taxes and then let the account grow over time?
A financial advisor can help you run the numbers and see the potential profit over time in several scenarios.
(For more, see: Roth vs. Traditional IRAs: Which Is Right For You?)
No RMD
As previously mentioned, Roth IRAs are not subject to RMD like traditional IRAs. It can make sense to do a partial
Roth conversion over a number of years to reduce the amount in a traditional IRA account that would have cost RMD at age 70.
Clients and their financial advisors may look at their income each year and plan to do a partial conversion in years
when the client’s income may be slightly lower than usual in an effort to “fill their tax bracket.”
For example, for clients retiring early in the year. The 60s, their income may drop in retirement.
Doing a Roth conversion might make sense in this time frame to reduce RMD in the next few years.
Tax Diversification
One way to deal with uncertainty about future income tax rates is to diversify your portfolio’s tax structure.
This may include a traditional tax-deferred retirement account such as an IRA or 401(k), along with taxable investments
and a tax-free Roth account. This diversification can be a hedge against future tax rate changes and can be a good reason to make a Roth conversion.
(For more, see: Retirement Advice for IRA Holders.
Young Investors
Younger clients who have years until retirement may be good candidates for a Roth conversion.
The thought process here is that they will have years of investment in the account to become
tax-free and this can easily offset the cost of taxes paid at the time of conversion.
Additionally, younger investors may be in the lower income tax bracket which would make this option more attractive.
Offsetting Reduction
Roth conversions can make sense for years when the client has goods that can offset some or all of the taxes
that are due at the time of conversion. Maybe it’s some kind of special deduction or some loss that can be made from previous years.
Any item like this can remove some of the contentions.
Drop Market Value
After a downturn in the stock market, you might consider doing a Roth conversion with a reduced account value. The theory here is that you will pay fewer taxes and the account will then have a chance to recover in the tax-free environment of a Roth IRA. (For more, see: Converting a Traditional IRA Savings to a Roth IRA.)
Peak Resident
Clients who are in their 50s or early 60s and are in the peak of their income years may want to avoid converting because of the tax rate. They have fewer years for a Roth account to recover money spent on taxes and may not make financial sense.
Charity Wish
Older clients with charitable leanings may not want to make a Roth conversion because leaving a traditional IRA to a charity is a very efficient way to donate. Charities are not subject to income tax and IRA amounts are excluded from a client’s gross assets that come into play if they are subject to land taxes. (For more, see Estate Planning Tips for Financial Advisors.
