Determining if a Roth Conversion Is Right

Tax rates, market declines and the stimulus bill make this a good year to consider a Roth conversion.
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A Roth conversion can be an effective planning tool for financial advisers, and current conditions make 2020 a solid year to consider a Roth conversion.

These include continued low tax rates for individuals, lower account valuations currently due to the stock market decline arising from the COVID-19 situation, the waiver on required minimum distributions (RMDs) as part of the CARES Act and the changes in the rules for many non-spousal beneficiaries of inherited IRAs included in the SECURE Act as far as the timing of distributions from the account.

Older clients doing a conversion will not have as long a time period to recoup the costs of the taxes that need to be paid on the Roth conversion as would a younger client. This is especially key for clients who will be taking funds from their IRA sooner than later as part of their planned income during retirement.

Can they pay the taxes with outside funds?

This is a key factor for clients of any age. If they do not have cash outside of their IRA account available to pay the taxes on the conversion, the cost of the conversion rises quickly. If some or all of the tax is paid with money converted, you end up with less money in the Roth account and this negates some of the benefits of doing the conversion in the first place.

For those who are under age 59½, paying the tax with funds from the traditional IRA could trigger a 10% penalty, making this process even more expensive.

Estate Planning

A Roth IRA account can have several estate-planning benefits. First, there are no required minimum distributions from a Roth IRA. For clients who don’t need the money from their RMDs and who wish to pass this money on to their account beneficiaries, converting a Roth IRA can help accomplish this.

As mentioned above, the new rules for inherited IRAs for most non-spousal beneficiaries associated with the SECURE Act can make converting to a Roth IRA desirable. While most non-spousal beneficiaries will still have to withdraw the full amount of the inherited Roth IRA within 10 years, they won’t have any taxes to pay. This can be beneficial, especially if it is anticipated that these beneficiaries will be in a higher tax bracket than your client’s current tax bracket.

Anticipated Future Tax Bracket

A key factor in determining whether or not a Roth conversion is a good move for a client is your best estimate of what their future tax situation in retirement might look like.

If they will retire with a pension plus the tax impact of withdrawing funds from traditional IRAs and other retirement accounts, their tax rate could remain high or possibly be higher than it is currently. This might indicate that a Roth conversion would be beneficial.

On the other hand, especially if the client is a high earner, their tax situation in retirement could be more favorable. This might indicate that a Roth conversion doesn’t make as much sense currently.

Certainly projecting a client’s anticipated future tax situation is an inexact science at best. Their situation could change for any number of reasons. Additionally, the tax rules can and do change.

The uncertainty surrounding what might or might not happen with future tax law changes can be an argument in favor of a Roth conversion for those clients whose retirement savings are concentrated in traditional IRAs, 401(k)s and other similar retirement plans. For retirement savers in this situation, converting some of their traditional retirement plan assets to a Roth account can help them achieve a level of tax diversification within their retirement accounts. This can be valuable in hedging their tax bets against whatever the future holds in terms of tax legislation.