Contributed by: Dale Shaw, CFP, RICP
As wealth advisors, one of the most common questions we address involves the value of Roth conversions as part of a comprehensive financial strategy. While Roth conversions can be a powerful tool for tax efficient retirement planning, they are not a one size fits all solution. It’s essential to weigh the advantages and disadvantages carefully, considering your unique financial circumstances, goals, and timeline.
This article outlines the primary benefits and potential drawbacks of Roth conversions, helping you make an informed decision.
What Is a Roth Conversion?
A Roth conversion allows you to move money from a traditional IRA or 401(k)—where contributions and growth are tax deferred—to a Roth IRA, where future withdrawals can be tax free if certain conditions are met. The catch? You’ll pay income taxes on the amount converted in the year of the conversion.
Roth conversions often appeal to individuals seeking greater tax diversification or those with a long term strategy to reduce taxable income in retirement.
Advantages of Roth Conversions
1. Tax Free Growth and Withdrawals
Roth IRAs can provide tax free growth and withdrawals in retirement, assuming you meet the requirements (e.g., the funding was at least five years ago, and you are age 59½ or older). For those anticipating higher tax rates in the future, this can be a significant advantage.
2. No Required Minimum Distributions (RMDs)
Unlike traditional IRAs, Roth IRAs are not subject to RMDs during the account holder’s lifetime. This makes them an excellent tool for managing taxable income in retirement and preserving assets for heirs.
3. Estate Planning Benefits
Assets in a Roth IRA can be passed to heirs income tax free. While the SECURE Act now requires most beneficiaries to withdraw inherited IRA funds within ten years, the absence of income tax on Roth withdrawals remains a significant advantage for family legacy planning.
4. Tax Diversification in Retirement
By diversifying the types of accounts you own (traditional IRAs, Roth IRAs, taxable brokerage accounts), you can better manage taxable income during retirement. Roth accounts allow you to withdraw funds tax free when needed, potentially reducing the impact of taxes on Social Security or Medicare premiums.
5. Opportunistic Conversions
If you experience a year of lower income, perhaps due to retirement, a career transition, or a temporary dip in business revenue, a Roth conversion can allow you to take advantage of lower tax brackets to move funds to a Roth IRA at a reduced tax cost.
Disadvantages of Roth Conversions
1. Immediate Tax Liability
The most significant drawback is the immediate tax bill. When you convert funds, you must pay ordinary income tax on the converted amount. If not planned carefully, this could push you into a higher tax bracket, creating a larger than anticipated tax burden.
2. Potential for Lost Benefits
A Roth conversion could increase your taxable income in the conversion year, potentially affecting other financial factors. For example, it could raise Medicare premiums (through income related monthly adjustment amounts, or IRMAA) or reduce eligibility for financial aid or tax credits.
3. Short Term Cash Flow Impact
Paying taxes on a conversion requires liquidity. If you lack sufficient cash outside the IRA to cover the tax bill, it may be less beneficial to proceed. Using IRA funds to pay the taxes negates some of the benefits by reducing the amount available for future growth.
4. Timing and Market Conditions
If market conditions shift negatively after a conversion, the expected benefit of tax free growth could diminish. As of a law change in 2018, you can no longer reverse a Roth conversion if circumstances change, so timing can make a difference, at least in the short term.
When Does a Roth Conversion Make Sense?
Roth conversions are most advantageous in specific scenarios, such as:
- Early Retirement Years: When taxable income is lower before Required Minimum Distributions (RMDs) begin.
- Down Markets: Converting assets in a down market allows future recovery to occur in a tax free environment.
- High Estate Tax Concerns: If your estate exceeds the federal or state estate tax exemption, Roth assets can minimize income tax burdens for your heirs.
- Rising Tax Environments: If tax rates are expected to increase, locking in today’s rates can be prudent.
How Granite Harbor Advisors Can Help
Roth conversions require careful planning to avoid unintended consequences and maximize benefits. At Granite Harbor Advisors, we specialize in sophisticated financial strategies that align with your long term goals.
Our team can help you:
- Perform a Detailed Tax Analysis: Understand the immediate and long term tax implications of a conversion.
- Develop a Comprehensive Plan: Coordinate Roth conversions with your broader financial strategy, considering estate planning, charitable giving, and cash flow needs.
- Identify Optimal Timing: Evaluate income levels, market conditions, and future goals to determine the right time to convert.
Roth conversions are a complex decision, but they can be a transformative part of your financial plan when executed correctly.
For personalized advice on whether a Roth conversion aligns with your financial goals, contact Granite Harbor Advisors. Together, we can design a strategy that simplifies the complexities of wealth management and secures your financial future.