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? For most investors, while they are still working. They should wait until they are in a lower tax bracket before withdrawing money from IRAs, 401(ks) 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.
Who should stay the course and keep their tax-qualified savings in those accounts? Investors with modest IRAs and brokerage accounts will benefit little from Roth conversions. New retirees in good health are also probably better off using some of their tax-advantaged savings to finance living expenses and delay Social Security (to age 70, if possible) to get the maximum benefit from the government.
What techniques can make Roth conversions more valuable? Asset location is the practice of choosing what investments to place in what accounts based on the tax treatment of the accounts. Applying this to Roth conversions means that investors should locate their high-returning assets in those accounts.
Another technique applies again to couples with a significant age gap. Voluntary IRA withdrawals from the older member to fund Roth conversions can help minimize RMDs and provide for the younger spouse when widowed.
Are Roth conversions a good tool for estate planning? Yes, they are an excellent tool. Heirs who inherit Roth IRAs aren’t taxed on withdrawals. They are taxed on withdrawals from traditional IRAs (setting up a complicated situation for the financial advisor, tax accountant and the heir to figure out).
Remember this…Conversions need to occur over many years and depend on the tax brackets of investors in those years. This requires software that combines an accurate tax calculator with multi-period projections to inform investor choice.
Most Roth conversion calculators that investors find online aren’t up to the task. They look only at a Roth conversion in a single calendar year and assume it’s possible to estimate future tax rates on withdrawals from qualified accounts. They’re as good as a broken analog clock is in providing the time: it’s accurate for one minute twice a day.
Advisors who stay close to their clients and are agile—they revise recommendations based on market returns and clients’ situations—will benefit by retaining more assets under management and possibly earning the business of younger family members and associates.
Paul R. Samuelson is the chief investment officer and co-founder of LifeYield.