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 below).
The benefits of a Roth IRA include:
• Investors don’t pay taxes on future withdrawals (making Roths a nice rainy day fund).
• There are no minimum required distributions (RMDs) as there are for traditional IRAs and 401(k)s. RMDs can drive up taxes for individuals age 72 and older.
• Roth IRA assets can pass tax-free to heirs (rules apply, of course).
Under what circumstances should an investor (and financial advisor) consider a Roth IRA conversion? Many investors benefit when they:
• Are just entering retirement.
• Haven’t filed yet for Social Security benefits.
• Are still years away from having to take RMDs (now starting at age 72).
Describe more about investors for whom Roth conversions make the most sense. These 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.