Should You Convert Your IRA or 401k to a Roth IRA?
There was a lot of hoopla when the rules were changed a few years ago to allow any taxpayer, regardless of income level, to convert IRA's and retirement plans to Roth accounts. So much so that you would think Roth conversions were "no-brainer" decisions. But in reality, a Roth conversion probably only makes sense for a minority of investors. Here are some of the major factors to consider in deciding whether to convert your IRA or retirement plan account to a Roth IRA.
The Roth conversion decision should be thought of as a trade-off between paying a known amount of additional taxes now versus paying an unknown amount of taxes some time in the future. The IRS gets its pound of flesh one way or another. And all other factors remaining equal, it's advisable to write Uncle Sam a check later rather than sooner. For this reason, an existing retirement account shouldn't be converted unless there are compelling reasons to do so.
For one subset of taxpayers, there are compelling reasons to convert to a Roth IRA for estate planning purposes. Conversions can make a lot of sense for those who view required minimum distributions (RMD's) as annoyances rather than as a way to help meet retirement living expenses, and who have a desire to leave retirement accounts to beneficiaries.
By converting, investors in this situation stop the annual erosion of their account's value (and the annual tax liability) dictated by the RMD process. Furthermore, the one-time tax bill resulting from the conversion reduces their estate, and any future growth in the value of the converted account is forever safe from income taxation, on either them or their beneficiaries (assuming no future changes in the related tax code to the contrary). By converting to a Roth, investors in this situation are, in effect, making a tax-efficient gift to their beneficiaries.
For the rest of us, the decision to convert is much more complicated and tenuous. However, we can say that converting to a Roth IRA is a more attractive proposition:
* if the resulting tax bill can be met from sources other than retirement accounts,
* the longer the converted account has to grow until withdrawals must be taken by either the account owner or his/her beneficiary,
* the greater the expected return in the account, and
* the higher the future tax rate applicable to the owner or beneficiary at the time of eventual withdrawal is relative to the current marginal tax rate applicable to the owner.
To complicate things even further, if you decide a Roth conversion is right for you, you have additional decisions to make about implementation. Should you convert all of your account(s) this year, or just a part of them each year going forward? Your choices may not only affect your ability to qualify for various income tax deductions, exemptions, and credits, but may also have an impact on financial aid for your college-bound kids and/or your future Medicare premiums.
Far from being a "no-brainer", the choice to convert to a Roth IRA is a veritable "multi-brainer", a decision that should ideally involve you and your financial team putting your heads together.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.