Hugh F. Wynn
Roth Conversions are Righteous - Under the Right Conditions
If you have money tied up in traditional IRAs and/or 401(k)s, you might wonder if, when, and how you can convert those funds to Roth accounts. The “if”, of course, assumes that such a move makes sense financially. Let's explore your options. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Yes, you can convert funds from your traditional individual retirement account (IRAs) and/or 401(k)s to a Roth IRA account. What is a Roth, you ask? It is an individual retirement account where you pay taxes on money going into your account, and then all future withdrawals are tax-free. The biggest difference between a Roth and a traditional IRA is that contributions to a traditional IRA are generally made with pre-tax dollars - you usually get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during retirement.
Because you pay taxes on Roth contributions, you can withdraw those contributions at any time and for any reason, tax free – but not earnings on those contributions. (However, withdrawals are not recommended - these ARE tax-advantaged retirement vehicles). In addition, you don’t have to take Required Minimum Distributions (RMDs) from your Roth account beginning at age 72. Annual RMDs from traditional IRAs – whether needed or not – are a must.
A Roth IRA conversion happens when you transfer retirement funds from your traditional IRA or 401(k) into your Roth account. Since the traditional/401(k) is tax-deferred and the Roth is tax-exempt, you must pay the deferred income taxes due on the converted funds at that time. However, there is no early withdrawal penalty.
Most traditional IRA account holders are aware that conversions to Roth accounts are possible, but are wary to make them because of the tax implications. So, the question is: Are you in a tax bracket such that it makes sense to convert traditional funds to Roth funds now, or should you wait until you're in a lower tax bracket?
To my way of thinking, it’s never too soon to start doing Roth conversions. Particularly if you believe that you’ll pay less taxes on the money being converted today than you would on withdrawals from your retirement accounts later in life. But that’s a tough call.
Logically, in the years right after retirement (and before RMDs from tax-deferred accounts kick in at age 72), your taxable income will likely be less than when you had a job. Most of the money you use to pay expenses will probably come from Social Security or other non-retirement accounts. If you wait until then (your retirement years) to make those Roth conversions - instead of in your 30’s, 40’s and 50’s - you’ve given up years of potential tax-free earnings (interest, dividends and capital gains) on your investments. Yes, by not converting early, you won’t pay taxes on those earnings until RMD withdrawal time, but that day will surely come. It’s not a matter of if you’ll pay…but when.
When you decide it's time to start making Roth conversions, you don’t have to do them all at once. In fact, a large Roth conversion could push you into an even larger tax bracket (which causes some people to put off making conversion decisions). Start slow by converting smaller amounts over a longer period of time to avoid such an occurrence. By taking this approach earlier in your career, you can enjoy watching those newly converted Roth dollars grow for several decades before retirement.
This moderate approach is probably best for most investors. And whether you believe it or not, today’s personal income tax rates are relatively low by historical standards.
I’m a stickler for diversification. So, why not diversify your tax risks as well? Roth conversions involve speculating about when best to do the conversion. It’s certainly a game of chance…a prediction about what the future might bring, tax-wise. Don’t dump all of your retirement funds in “one tax basket”. Routinely converting small amounts of traditional funds to Roth funds makes for a simple and effective hedge against possible future tax rate increases.
Word Of Caution
Although I’m a big proponent of Roth conversions, they’re not for everyone. By definition, a Roth conversion creates a taxable event. You must pay the applicable tax on the money converted. If you’re not able to pay this tax on the conversion with money outside your traditional account, you’re short-changing yourself. And why is that? By paying the tax bill with money taken from your traditional account, you’re taking money that could later be converted to a Roth and handing it to the IRS. I shudder to think of a situation like that.
If you think higher taxes are in your future, make Roth conversions a part of your retirement strategy. But do it wisely.