The Roth IRA Conversion Discussion

One of the questions in the realm of financial planning that we often discuss with clients is regarding converting Traditional IRA’s to Roth’s. We thought it would be helpful to go through the details on this as it can be a bit confusing, but a significant tool when appropriate.

First, let’s discuss the difference between an IRA and a Roth IRA. An IRA (especially one with pre-tax or rollover funds) is a vehicle that allows for a tax deduction when contributed, tax deferred growth along the way, and all withdrawals are taxable when distributed. In addition, they are subject to RMD rules, and ultimately, non-spouse beneficiaries also must pay tax on their amounts received. Roth IRA’s offer no deduction on the front end, so after-tax funds are contributed. Like traditional IRA’s, funds grow tax-deferred along the way. However, what makes them different is that withdrawals are tax-free coming out, as well as to beneficiaries, and there are no RMD requirements. This trio can be very powerful.

So… One would think that everyone would want a Roth IRA. Right? Well, they are subject to income limitations on contributions, but many employer plans also offer this option without those limits. Often, the discussion comes down to immediate tax benefits on the traditional side vs the possibility of being in a lower income tax bracket in the future. Fair enough. But with that said, what are the guidelines for “converting” from a traditional IRA to a Roth IRA?

Let’s say an investor has $500,000 in a traditional IRA, maybe because of a rollover from their previous employer. In retirement, any withdrawals will be subject to ordinary income. And, as mentioned, they will also be required to take required minimum withdrawals when reaching the appropriate age. (73 for many). If they “convert” that existing traditional IRA to a Roth, (making their traditional IRA a Roth), they will avoid both of those things, as well as whatever is left will pass to the heirs tax-free. HOWEVER, when we do this, the amount converted will be taxable in the year converted. In addition, the taxes need to paid with outside funds, as the funds in the IRA cannot be used. Meaning, if we convert, $500,000 will be taxed in the current year and we need to have enough cash to pay the taxes. This can quickly change whether this is as good of an idea as we originally thought, including how it affects income tax rates, Medicare planning, etc. 

One more thing. There is also something that should be evaluated as part of the equation. That is the break-even analysis on the possible conversion. Meaning, if we convert, we are paying taxes, and that money could have been invested. How long will it take in years to break even based on life expectancy?                

Here's the bottom line. We believe that using Roth IRAs as a vehicle for wealth creation and legacy planning are one of the most significant tools in existence. However, many factors need to be looked at comprehensively, including current income, tax bracket, legacy intentions, income needs, estate planning, etc. We do not believe that Roth conversions are a one size fits all approach and must be analyzed in each specific situation. 

And that’s that.

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