As you take stock of your own financial picture – especially your overall wealth and health outlook as you age – one question might arise: Is converting a traditional IRA to a Roth IRA a good idea?
Doug Ewing is glad you asked.
As a Certified Financial Planner®, lawyer, and director of Advanced Markets at Transamerica, Ewing has logged a lot of time evaluating the pros and cons of all aspects of retirement planning. Spend more than a few minutes with him and you’ll quickly learn he’s a fan of the Roth route – for both IRAs and 401(k)s. That said, he’s also a thoughtful, measured financial professional who knows how to present the case for both sides of an argument. Maybe that’s the lawyer in him.
Before hearing Ewing’s take, here’s a refresher on the basic differences between the two accounts.
Traditional vs. Roth
With a traditional IRA, contributions are tax-deferred so you’ll pay taxes at the time of distribution. Qualifying contributions are tax deductible for the year they are made. By age 70 ½, you’ll face required minimum distributions (RMDs). And, by that age, you won’t be able make additional contributions.
When contributing to a Roth IRA, you pay taxes before the money goes in. Therefore, you won’t get the tax break now, but the money in a Roth account grows tax-free. When you reach 59 ½ — and if your account is at least five years old — you’re eligible for income tax-free withdrawals. Additionally, there are no RMDs. Another upside is that you can continue to contribute to a Roth IRA as long as you have earned income. There’s no cut-off like there is with a traditional account.
For a deeper, side-by-side comparison, Transamerica offers this helpful guide. But the question remains does it make sense to convert from a traditional account to a Roth?
Well, remember those deferred taxes? So does Uncle Sam. You’ll have to pay income tax on the pre-tax amount you’re converting – which could mean the total amount in the account is taxable.
But, depending on your age and financial status, that’s not necessarily a bad thing.
When does a conversion make sense?
Ewing says a general rule of thumb suggests that the more time you have for the Roth IRA to cook, the better off you’ll be. So by that measure, you could assume Roth conversions generally favor the young. That’s true. You’ll pay the taxes in the conversion process, but with many years of tax-free growth ahead, that might still be a good option. Keep in mind, any subsequent growth could be subject to taxes and a 10% penalty if you withdraw it before you turn 59 ½. But as long as you wait five years after the conversion and you’ve reached 59 ½, you can withdraw the converted amount without penalty.
If you’re retired, there are additional considerations when looking at a conversion.
“Normally, if someone is already retired, doing a Roth conversion might not make a lot of sense,” Ewing says. “For one thing, if you’re on Medicare, a Roth conversion will increase your income. In turn, your taxes will go up and your Medicare Part B premium will spike – probably a couple hundred dollars a month.” The increase in premiums only lasts a year – the second year after the conversion. After that, rates should return to preconversion prices assuming your other income doesn’t change.
Ewing likes to point out that just because you’re retired doesn’t mean you should rule out a Roth conversion for your traditional IRA.
Estate planning and wealth transfer
“It’s sometimes overlooked, but another potential advantage to a Roth conversion is in estate planning and wealth transfer,” Ewing says.
If you intend to convert it, never touch it (Roth IRAs don’t have required minimum distributions), and then leave the account to a beneficiary, this could be a strategy worth considering.
Ewing uses this scenario: Let’s say you’re very wealthy with a net worth over $11 million. That means you’ll have exposure to estate taxes. In this example, your beneficiary (an adult child) is also very successful and already in the top tax bracket at 39.6%.
You convert a $1 million traditional IRA and pay $400,000 in income taxes. That may seem like a lot, but stay with us. If you’re able to pay that tax bill from other assets, the full $1 million Roth account remains intact. Then you live another 15 years and the account grows to $2 million.
When you die, your beneficiary inherits a $2 million Roth IRA. Your child takes required life expectancy distributions for the rest of his or her life—maybe 30 years or so. We’ll assume your child only takes minimum distributions (tax-free) and earns another $1 million in growth over those three decades. That’s a $400,000 tax bill on what could ultimately become a $3 million account, and a very competitive 13% tax rate.
If you leave the $1 million traditional IRA (plus $400,000 tax savings) to your beneficiary and the account has similar growth, he or she may net around the same amount. But your beneficiary will pay 40% along the way, or $1.2 million in taxes. Of course, this assumes tax rates on high earners stay the same, which we can’t predict. Also consider the $400,000. If that doubled in the years before your death, that’s $800,000 in your taxable estate, which is also subject to a 40% estate tax.
Ewing admits it’s not a purely mathematical argument. The net amount left to your beneficiary could end up being about the same or even less. But the Roth conversion strategy means prepaying to lock in a smaller tax bill in dollar terms. And it also protects your beneficiary against the prospect of higher tax rates in the future.
There are, of course, other details to consider and you’ll want to discuss your options with a financial professional. Evaluating your financial strategies in relation to your overall wealth and health is important as you progress through life. But Ewing’s biggest point is to not rule out a conversion due to your age.
Neither Transamerica nor its agents or representatives may provide tax, investment or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal advisors and financial professional regarding their particular situation and the concepts presented herein.
Things to Consider:
- Consider a Roth conversion if you’re young. You’ll pay a tax bill for the conversion, but that account can then grow tax-free. Assuming you wait five years and reach 59 ½, you’ll also have greater access to those dollars and avoid required minimum distributions.
- If you’re leaving an IRA to beneficiaries, a Roth conversion might help them avoid a big tax headache. You will have already paid the taxes and left them an account that can continue to grow tax-free. (Some rules apply. They’ll have to take annual distributions based on life expectancy.)
- Instead of paying the tax bill from the IRA account, consider using other assets. This lessens your own estate tax liability and leaves a bigger Roth account intact for your beneficiary.