Most investors are aware of the benefits of a Roth IRA, including tax-free distributions in retirement—for either the investor or the heirs. Roth IRA conversions allow investors, who are above the income limit for contributions, to pay taxes on their retirement funds today, enabling the funds to grow tax free.
While the benefit sounds straightforward, the devil is in the details.
Almost every investor’s goal is to pay the least amount of taxes as legally possible. That doesn’t change the fact that the more money you make, the more you’ll pay in taxes. So, while the lure of tax-free distributions in retirement makes the Roth conversion very attractive, the reality is it only makes sense to do so when your financial situation makes it advantageous.
Recently, we were working with an investor who earns more than $400,000. She feels that she is in the crosshairs for a Biden Administration tax hike. Her gut reaction was to convert some of her tax-deferred IRA funds to a Roth IRA to ensure tax-free income in the future. On the surface, she’s thinking like a tax-savvy investor; however, looking at her overall financial situation, we found some cracks in her plan.
To start, this investor is 60 years old and in her prime earning years, putting her squarely in the highest current tax bracket. She also did not have a set retirement date. Generally, when we look at Roth conversions for seniors, we look for a window of opportunity when their taxes are lower—usually the first few years of retirement when the investor is living on their taxable investments before they are required to take mandatory distributions from their tax-deferred accounts. If this investor chose to convert tax-deferred funds today, she would be paying at least 35% income tax, plus the 3.8% Medicare tax. She could use the money needed to pay the taxes due on the conversion elsewhere and with potentially generous returns. Furthermore, without a retirement date and her substantial amount in a tax-deferred company retirement fund, there was no need to withdraw the money for living expenses in the next few years. Tax policy is revised all the time under different presidential administrations. There is no predicting what tax rates may be at an unspecified date in the future.
Additionally, the general order of spending retirement assets is first from taxable accounts, then tax-deferred account, and lastly tax-free accounts, which brings an additional unknown to the investor’s situation—will she live long enough to spend the tax-free assets? If she is converting the assets for the benefit of her heirs, what is their tax situation, and is it necessary to shoulder the tax burden for them?
Roth conversions are a very useful strategy, but whether it makes sense for you is very dependent on your situation. Your age, income, current tax situation, and how soon you need the money all play into whether a Roth conversion makes sense for you.
If you have questions on Roth IRA conversions, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
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