Shrewd investors look for opportunities no matter how bad the economic outlook. With their investments down from the glorious highs of only a few months ago, some clients (particularly those hovering around retirement) may be seeking advice on Roth individual retirement account (IRA) conversions.
Of course, no situation is the same, and advice must account for all the variables for each client and their family. Still, Roth conversions are among the transactions advisors need to consider in their quest to minimize taxes and maximize retirement income.
Here is my quick guide to client conversations about Roth IRA conversions. These are rules of thumb. You need sophisticated financial planning and tax calculation software to provide the best advice.
What are the short- and long-term benefits of Roth conversions?
A Roth conversion involves liquidating assets in a tax-advantaged account like a traditional IRA or 401(k), paying taxes on the withdrawal, and then funding a Roth IRA. So, in the short run, investors will pay taxes (more on that later).
The Roth IRA offers these benefits:
• Investors don’t pay taxes on future withdrawals (making Roths a nice rainy day fund).
• There are no minimum required distributions for Roth IRAs as there are for traditional IRAs and 401(k)s. RMDs can drive up taxes for people age 72 and older.
• Roth IRA assets can pass tax-free to heirs (rules apply, of course).
Under what circumstances should investors (and their financial advisors) consider a Roth IRA conversion?
Many investors benefit from conversions under these conditions:
• When they are just entering retirement.
• When they haven’t filed yet for Social Security benefits.
• When they are still years away from having to take RMDs (now starting when they are 72).
Describe further those investors for whom Roth conversions make the most sense.
Such investors have at least moderate-size IRAs and brokerage accounts and don’t foresee needing all their assets to pay day-to-day expenses in retirement. They have annuities or pensions and delayed Social Security files to optimize their benefits.
Married couples with a significant age gap may also be good candidates. When one spouse—assumed to be the older one—passes, the widowed spouse will have a lower tax bracket and, with an inherited Roth, require less income from traditional IRA or 401(k) withdrawals.
Very wealthy investors will often benefit from well-planned conversions, even when taxed at relatively high brackets. And investors with company founders’ shares priced below their market value can avoid taxes entirely by transferring technically worthless stock into a Roth account.
When should an investor not do a Roth conversion?
Most investors shouldn’t while they are still working. They should wait until they are in a lower tax bracket before withdrawing money from IRAs, 401(k)s and similar accounts.
Investors should also avoid making too-large conversions in a single calendar year but stagger conversions over several years.
No one should do a Roth conversion out of fear of future tax rate increases. Those are simply unpredictable.