To convert or not to convert? Too often investors want to convert to a Roth IRA without fully understanding the risks, benefits, and how a potential conversion fits within their entire plan.
This is a different type of Roth conversion post. We aren’t going to tell you about the differences between a traditional IRA and Roth IRA.
We are going outline good and not-so-good reasons to convert.
Why is this a big deal?
Because of a subtle change in 2018 that makes the stakes higher than ever for a Roth conversion. The elimination of recharacterization, which means once you execute a Roth conversion, there’s no going back. Previously, one could reverse a Roth conversion if their tax bill was too high or the market tanked post-conversion.
Good Reasons to Convert
You will be in a higher tax bracket later. This doesn’t mean you’re certain the government is out to screw you by jacking up tax rates. Rather, you’re confident your income is likely to go up in the future or you’re moving to a higher income tax state in retirement.
The market tanked. This is going to take some courage, writing a check to the Feds and seeing your account value crater probably doesn’t feel very good. This isn’t a primary reason to convert per se, but if you’ve decided that a conversion is right for you, it’s better to do it when the market is lower.
You don’t want to mess with required minimum distributions (RMDs). Roth IRAs don’t require an RMD at age 72 (or any age for that matter). No more confusing calculations, taxes owed, and changing RMD rules.
You want to leave tax-free monies to your beneficiaries. Let’s say your kids inherit your Roth IRA. They will never pay taxes on the proceeds (assuming the account has been open for five years).
Roth conversion can be thought of as diversifying your future tax exposure. You might have an IRA which is taxable when you pull the money out. You might have a Roth that is never taxable. You might have a joint account that is subject to lower long-term capital gains.
We should note that deciding whether to convert isn’t an all or nothing proposition. You can convert a small amount every year to see how it feels writing a check to Uncle Sam.
The decision to convert should be made in the context of your financial plan. You can easily run two scenarios, Roth conversion vs. no Roth conversion, and see how it affects the long-term glide path of your plan.
For example, scenario A might be to convert $100k per year over the next five years.
Scenario B might be no conversion. Are you better or worse off converting?
Obviously, even with proper modeling, there are variables that are unknown i.e. future tax rates and financial market returns. If we knew financial markets would scream higher for the next 10 years, converting everything would be a no-brainer.
Not-so-good Reasons to Convert
Trying to predict future income tax rates. We’re not talking about your personal rate based on income, but statements like “I just know the government is going to raise taxes in five years!”
You don’t have cash to pay the taxes owed. If you’re using qualified money (IRA, 401k) to pay taxes for the conversion, you’re going to owe more taxes and potentially pay a 10% penalty if you’re under 59.5 years old. In general, it’s best to pay taxes owed with after-tax money.
Your income is going to be low in retirement. If you’re income is going to crater in retirement, doing nothing could save you an unnecessary tax bill.
Still on the fence about converting? Or want to have a Roth IRA without paying a hefty tax bill?
You can directly contribute to a Roth IRA. You can check your eligibility based on income here.
Does your employer have a Roth 401k? If so, you can contribute regardless of your income.
If you make too much to contribute to a Roth IRA, check out the backdoor Roth option here (this might be going away Jan. 1).
The biggest risk to converting, especially a sizable amount, is the market tanking post-conversion. You’re stuck with a large tax bill and a lower account value. You can smooth out the tax liability and market risk by converting a smaller amount over multiple years, rather than all at once. Remember, once you convert, there’s no turning back.
Post conversion, make sure you’re Roth IRA is invested appropriately. You want assets that move (hopefully higher) to maximize the tax-free benefit. Let’s look at an extreme example…
Bush is a 30 year old that decides to convert a traditional IRA to a Roth account. The post-conversion balance is $100,000. Bush plans on working another 25 years.
Roth Conversion Portfolio A: Bush invests 100% in U.S. Treasury bonds earning 2% per year for 25 years. At the end of 25 years, Bush’s Roth IRA balance is ~$164,000.
Roth Conversion Portfolio B: Bush invests 100% in U.S. Small Cap Value stocks earning 10% per year for 25 years. At the end of 25 years, Bush’s Roth IRA balance is ~$1,208,184.
Bush has created an additional $1,044,00 in tax-free monies.
In general, your Roth should be invested more aggressively than your other account types (traditional IRA, taxable, etc.). However, if your Roth IRA is 100% of your investable assets, you should invest consistent with your risk tolerance (here’s how we capture an investor’s range of acceptable outcomes).
You can learn more about asset location and tax-efficient investing strategies, including allocating Roth IRA assets here and here.