Roth Conversions – Are they right for you?

If you’ve ever visited a finance focused website or watched a prominent financial news program, you’ve likely been encouraged to consider Roth Conversions as a smart financial move. What these sources often over look are the different financial characteristics and unique needs that each individual has.  Roth Conversions are frequently presented as a strategy everyone should consider, but without the context needed to determine whether they actually make sense for you.

While Roth Conversions can provide significant value in the right circumstances, the reality is that simply owning a traditional pretax IRA does not mean you should convert it. Following generalized advice from online commentators or television personalities who are unfamiliar with your personal financial situation can sometimes lead to costly mistakes.

A Roth Conversion involves moving pretax dollars from accounts such as IRAs or 401(k) plans into a Roth IRA.  When you do this, the converted amount is added to your taxable income for the year and taxed at your marginal tax rates.  The goal is to pay taxes now in order to potentially reduce taxes on future distributions and reduce the impact of required minimum distributions.  While this may sound appealing, the true value of the strategy depends heavily on your individual circumstances.

Below are several key considerations that can reduce or eveneliminate the benefit of a Roth Conversion.

Current tax rate versus future tax rate

‍The primary goal of a Roth Conversion is to reduce the total taxes paid over time on distributed amounts.  The amount you convert is added to your income and taxed at marginal rates, meaning different portions may be taxed at different brackets as your income increases.  Because of this, a conversion can push some of your income into higher tax brackets.

In general, a Roth Conversion is most effective when your current tax rate is lower than the rate you expect to pay in the future.  This applies not only to your own retirement years, but also to the potential tax situation of your beneficiaries.  If you expect to be in a lower tax bracket later, converting at a higher rate today may not be beneficial.

Paying the tax bill

‍One of the most important and often overlooked factors is how you will actually pay the tax on the conversion.  Ideally, taxes should be paid using funds held outside of retirement accounts.  If you use IRA or 401(k) assets to cover the tax, you further reduce the amount remaining to grow tax advantage.  For individuals underage 59½, using retirement funds for taxes may also trigger penalties.

Using outside funds preserves more of the converted balanceand improves the likelihood that the strategy delivers a net benefit.

Time horizon

‍A Roth Conversion requires paying taxes today in exchange for potential benefits in the future.  Because of this, time is a critical factor.  The Roth account needs sufficient time to grow and offset the upfront tax cost in order to breakeven and provide value.

For individuals who expect to need the funds in the nearterm, there may not be enough time to reach a breakeven point.  This makes conversions less attractive forthose with shorter time horizons.

Hidden effects of higher income

‍Roth Conversions can increase your adjusted gross income in the year they occur.  This can create additional consequences beyond just federal income taxes. A higher income level may lead to increased Medicare premiums through IRMAA, greater taxation of Social Security benefits, and reduced eligibility for certain credits and deductions.

These secondary effects can meaningfully increase the true cost of a conversion and should be carefully evaluated with your advisor and tax professional.

 Charitable giving considerations

‍For individuals who plan to make charitable contributions, converting pretax assets may not be the most efficient approach. Qualified charitable distributions from traditional IRAs allow funds to go directly to charities without being taxed. Since charitable organizations do not pay income tax, traditional IRA assets can be particularly effective for giving.

Converting those assets first would create unnecessary taxliability and reduce the amount ultimately going to the charity.

‍Final thoughts

‍Roth Conversions have become a popular planning strategy due to their potential to reduce future taxes and create tax free portfolio assets.  However, their benefits are highly dependent on individual circumstances and should not be applied universally.

A thoughtful analysis that considers tax rates, time horizon, cash flow and broader financial goals is essential before implementing this strategy.  When used appropriately, Roth Conversions can be valuable.  When used without proper context, they can create unintended and costly consequences.

If you are considering a Roth Conversion and want to determine whether it aligns with your financial plan, speak with your Mesirow advisor.