A Roth IRA conversion is when you convert traditional IRA assets (paying the taxes now)
A Roth IRA conversion is when you convert traditional IRA assets (paying the taxes now) into a Roth IRA in order to enjoy tax-free growth and withdrawals later. Currently, there are multiple factors converging to make Roth conversions more promising than ever before.
Factors
Although we do not advocate timing the market, timing your conversion is something that can be done. History suggests that after every crash there is a recovery. If the market goes up after you make your Roth conversion you will be getting a bargain.
Let’s say you have a traditional IRA that was valued at $133,000 at its peak and today is worth $100,000. If you were to do a conversion today, you would pay taxes on the $100,000. Then, when the market recovers to its pre-crash levels your new Roth IRA would be worth $133,000. You would have essentially gotten a bargain by paying taxes on the $100,000 and getting a $133,000 tax-free Roth IRA in return.
I’m sure you are all aware of the nearly $2 Trillion fiscal spending bill that congress passed a few weeks back. Well, between our current deficit and this new bill, it isn’t a huge leap to assume taxes will be higher in the future. So, converting your traditional IRA to a Roth and paying the taxes now at what we think will be lower rates may be a smart move.
Remember this bill? Well, one of the not so great provisions was the elimination of stretch IRA’s. This would accelerate income tax on inherited IRA’s within 10 years of the original owner’s death. This makes planning your estate much more difficult. However, if you were you pass a Roth IRA to your heirs, they would not owe any tax on the withdrawals.
Why a Roth Conversion might not make sense
While a Roth conversion sounds like a no brainer it doesn’t make sense for everyone. Everyone’s situations is different, and a lot of factors need to be considered before deciding on a conversion. The most important factors involve your tax situations.
You need to be able to pay the taxes on the conversion. Let’s revisit the $100,000 conversion example from above. That $100,000 would be taxed as income in the year of the conversion which could push you into a higher tax bracket. So, before you decide you need to have a plan on how you are going to pay the taxes.
You also need to consider your current tax rate versus what it will be in retirement. We always like to plan for higher taxes in the future but that is not always the case. If you are planning on living off less income in retirement, then your tax rate could be lower than it is now. In which case, paying taxes on IRA assets now would not make sense.
Pros and Cons of a Roth Conversion Summary
| Pros | Cons |
| Tax free growth and withdrawals in retirement | Will raise your taxable income in the conversion year |
| Market is well off its highs | Conversion could put you into a higher tax bracket |
| Future tax rates will most likely be higher | Your individual tax rate might be lower if you are taking less income |
| Roth’s are better for estate planning after SECURE Act | Finding the money to pay the taxes |
Conclusion
If you are considering a Roth conversion it is important that you work with both your financial advisor and tax professional. If you have questions on whether it makes sense for you, give us a call at 610-825-3540.
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