An increasingly popular retirement planning strategy is to do Roth conversions. Simply put, this is either a one-time or systematic conversion of pre-tax 401(k) or Traditional IRA assets to Roth IRA assets. I won’t get into the specifics of how Roth conversions work (you can find that here) but I’d like to cover 3 reasons a Roth conversion could be right for you. You’ve already heard about converting in a market downturn (less tax on your conversion than in a strong year), converting while in a lower tax bracket than while you were in peak earning years (creating tax arbitrage), or converting so that you can potentially access more money at an earlier age. Those are all great reasons to consider a Roth conversion, but here are 3 other reasons that you may not have considered.
Optimizing Your Legacy
A law went into place in 2019 that has made leaving pre-tax assets to a beneficiary less beneficial than it was previously. Many of our clients plan to leave most if not all of their retirement assets to their children someday. The tax law change has made it so that these beneficiaries, assuming here that they are your children, will need to deplete that inherited account by the end of the 10th year after your death.
Don’t get me wrong, no one is going to be upset about an inheritance. But there are some reasons why this may be less than optimal. It can cause your beneficiaries to pay higher health care premiums, can mean more of your legacy assets end up with the IRS than the intended parties and can impact any aid a grandchild was getting for higher education. These are just a few of the ways required distributions from an Inherited IRA can be less optimal than a Roth IRA.
Let’s say that you converted your pre-tax assets to a Roth IRA over 10 years, thus trying to manage the tax burden of doing so and that your kids inherited this Roth IRA. This is now a much cleaner and more optimized way to inherit assets. The distribution issues discussed above are gone. Even though the Roth still has the 10-year distribution rule, those distributions are tax-free, so even if the entire balance is taken out on day 1, there aren’t tax bracket concerns.
For anyone who finds themselves needing to take Required Minimum Distributions (RMDs), they should look into if a Roth conversion strategy makes sense. Let’s say that you’ve accumulated a sizable amount of wealth in pre-tax accounts that are subject to RMDs. Let’s say that you find yourself being required to take much more money out of those accounts than you need to live on. Well, the IRS isn’t going to care whether you need the money now or not. They feel that they need it now.
In this case, the best practice would be to estimate what those RMDs could look like in future years and start planning now to avoid those unnecessary RMD amounts. You could do a series of Roth conversions over several years so that your RMDs are only the amount you’ll need, leaving the newly converted Roth portion in a position to keep growing tax-free for later use (or better to leave to your kids as previously mentioned). Roth IRA assets are not subject to any required minimum distributions. Another option in this case is to consider qualified charitable distributions.
All of Your Money is Pre-Tax
Another issue we often see is that the vast majority, if not all, of a family’s retirement assets are in pre-tax accounts. We like for our clients to have some tax flexibility during their retirement years. That way we can get creative when planning around Medicare premiums, ACA premium tax credits, and gift planning, among other things.
Let’s say that all of your money is in a pre-tax account and you find that boat you’ve always wanted. It costs $30,000 and you pay for it with your Traditional IRA assets. Well, it costs you $30,000 + the federal tax + potentially state tax. Without any flexibility as to where your spending comes from, every cent you spend will be subject to taxation. This is another reason why some Roth conversions could help you down the road. Making a big purchase with Roth assets isn’t going to push you into a higher tax bracket and subject you to the ripple effects that come with it.
All of these strategies should be accompanied by a sound financial plan and coordinated with your tax professional. There are many reasons to consider a Roth conversion strategy, these are three that I feel deserve more attention. Aligning your wishes with these types of strategies can get you on track to living your best financial life.
Written by: Nick Vail, CFP®