Roth IRAs are a hot topic these days. I get multiple media inquiries every week regarding the pros and cons of Roth conversions. But while they can be a great proposition for some people, for others they just aren’t a good idea.
A little background: A Roth IRA conversion is the process of moving money directly from a pretax account, such as a traditional IRA or 401(k), to a post-tax account (Roth IRA) and paying the tax bill in that year. This strategy has picked up momentum in the last few years, thanks to today’s historically low tax environment.
Even in the COVID age, I go to the grocery store a few times a week. Yes, I wear a mask and gloves. I enjoy trying new things, but there are also the quarantine staples. One of those staples is coffee. If I walk into Whole Foods and the Peet’s bag I normally buy for $10 is on sale for $7, I will stock up. The yellow tag below the coffee will tell me how long the sale will last. I save 30% for every bag I buy. No-brainer, right?
The idea behind a Roth conversion is the same. You are stocking up, or pre-paying taxes today, to avoid paying them in the future. The only reason this would make sense is if you believe that your future tax rate will be higher than your current tax rate. Time horizon is not a factor, despite what you might read. It is simply a bet: Current tax rate < future rate. The challenge is that there is no definitive yellow tag saying when and how much those tax rates will go up.
The Case FOR Roth Conversions: 2 Examples
1. You are in a tax valley: We have a client, Jim, who has been retired for a few years. His wife, Susan, is retiring Dec. 31. They worked and had good incomes for full careers and are now in their mid-60s. Once Susan’s wages drop off of the 1040, their taxable income will be lower than it has been in decades. They will live off cash and taxable investments.
At age 70, they will both have turned on Social Security and, by 72, they will be taking required minimum distributions from their retirement accounts. All else being equal, their taxable income, and thus, their tax bracket, will pop back up. That window of opportunity is a “tax sale” from age 65-70/72, when they could pay at a lower tax rate when moving money from a traditional IRA to a Roth IRA.
2. You believe tax rates will go up: Oh boy. People are passionate about this one! Whether it’s our ballooning debt, the upcoming election, or the fact that our current tax code is already set to expire on Dec. 31, 2025, this may be a reason to pay now.
Even if nothing else changes in the next five years, rates are set to go up with the expiration of the Tax Cuts and Jobs Act (TCJA) on that date. Like the previous example, this creates a sort of tax holiday for those who saw their tax bill drop thanks to the TCJA. If Joe Biden is elected and Democrats have enough influence in Congress, it is likely that the TCJA will be amended and certain tax rates will go back up.
The Case AGAINST Roth Conversions: 2 Examples
1. You are in your peak earnings years: Imagine the Peet’s Coffee example above. What if you walked into the store and instead of the bag costing $10, it’s $13? You would not buy that coffee until it dropped back down to a reasonable rate.
If you believe you are in your peak earnings years, on the verge of retirement, you should not convert. You will pay a premium on every dollar converted. Instead, you should be searching for deductions. You should defer your income until you can recognize it in a future, lower-tax year.
2. You are not liquid: Let’s say you convert $100,000 from a traditional IRA to a Roth IRA and owe $25,000 in taxes for the conversion. While certain custodians will allow you to withhold those taxes and let the $75,000 grow tax free, you typically want to have significant liquid funds to cover the tax bill from a separate pot.
The first reason for this is relatively straightforward: Tax-deferred accounts grow faster. So, if you have a choice of earning a 7% return in a taxable account or a 7% return on a Roth account, you would choose the Roth. Therefore, when figuring out which pot you want to turn over to Uncle Sam, pick the taxable.
If you’re under 59½ and use the IRA funds to pay the tax bill, you’ll also pay a 10% early withdrawal penalty on that distribution. At the end of the day, if there is not enough money on the sidelines to pay the tax bill, work on that before moving on to conversions.
Slow and Steady Wins the Race
We save certain clients significant tax dollars by doing Roth conversions over a period of years. The caveat to all of this is that you must know what you are doing. I have seen entire IRAs converted in a single year, with almost half the value of the account going to taxes.
If you put yourself in the first category and think a Roth conversion makes sense for you, the tricky part is the calculation. You should seek the help of a CPA or CFP. Typically, we will do a tax projection for the year to estimate your taxable income. We will then figure out how much “headroom” we have, or how much income we can realize before we jump into the next income tax bracket. We will usually convert that amount over a period of several years. However, don’t forget the impact your income can have on capital gains and Medicare premiums!
Yes, Roth conversions are trendy in the small world of financial planning. And yes, for a small segment of the population they can save big tax dollars. But ask yourself: Are you willing to write the check?
This is for informational purposes only and should not be construed as tax or legal advice. Please consult your tax or legal adviser.
Wealth Manager, Campbell Wealth Management
Evan Beach is a Certified Financial Planner™ professional and an Accredited Wealth Management Adviser. His knowledge is concentrated on the issues that arise in retirement and how to plan for them. Beach teaches retirement planning courses at several local universities and continuing education courses to CPAs. He has been quoted in and published by Yahoo Finance, CNBC, Credit.com, Fox Business, Bloomberg, and U.S. News and World Report, among others.