Would A Roth Conversion Benefit Your Retirement Plan?
Today, many investors choose to allocate their retirement savings to a Roth plan to capture tax-free qualified withdrawals during their retirement years. However, the Roth IRA wasn’t introduced until 1997. The relative newness of Roth has left many investors with significant Traditional retirement assets – even if they would have preferred to earmark their savings as Roth if given the chance.
If you find yourself in this situation, there is a solution – a Roth conversion. The choice between leaving assets in a Traditional retirement plan or converting them to Roth is multifaceted, but the decision often comes down to a few factors including taxes, inheritance preferences, and your retirement income strategy.
An Overview of Roth Conversions
A Roth conversion is completed by transferring funds from a Traditional IRA to a Roth IRA or from a Traditional 401(k) to a Roth 401(k). In certain cases, you can also complete a Roth conversion during an account rollover when you move from a Traditional 401(k) to a Roth IRA after leaving an employer or retiring.
The purpose of a Roth conversion is to realize the benefits of a Roth retirement plan. These include tax-free qualified withdrawals, freedom from Required Minimum Distributions [RMDs], and the potential for tax-free inheritance for your beneficiaries.
A Roth Conversion May Be Right for You If You Expect Lower Retirement Taxes
To decide if a Roth conversion is beneficial in your situation, you should first determine whether a Roth or Traditional retirement plan will provide a greater benefit to your retirement plan. This decision often comes down to taxes.
Start by comparing your current tax rate to your anticipated tax rate in retirement. If you expect your tax rate to remain the same or rise in retirement, a Roth account could provide a greater benefit. On the other hand, if you expect your tax rate to decline in retirement, you may opt to leave your funds in a Traditional account.
Roth Conversions Can Benefit People with High Anticipated Investment Earnings
When you make a qualified distribution from a Roth retirement account, both the amount you contributed, and the earnings are tax-free. Therefore, the return you expect to earn is also an important factor to consider when deciding whether a conversion will benefit your retirement plan.
If you anticipate high investment returns, converting to Roth could reduce your lifetime tax liability compared to leaving funds in a Traditional plan. Conversely, if you expect very low investment returns, the benefits of a Roth retirement plan may be minimal – making a conversion less worthwhile.
A Roth Conversion May Be a Good Fit If You Have Time for Your Savings to Work
The tax benefits of a Roth retirement plan compound each year as your investments accumulate more earnings. Therefore, if you are young or have many years before you need to access retirement savings, you may experience a greater benefit from a Roth account.
On the other hand, if you are nearing retirement or already drawing from your retirement accounts, you may see a reduced benefit from a Roth conversion. Additionally, consider that the Roth account must be open for 5 years before you qualify for tax-free withdrawals. If you plan to withdraw your funds within this timeframe, a Roth conversion may not be the best option for you.
Converting To Roth Can Be Wise If You Are Seeking Tax-Free Distributions for Heirs
Tax-free withdrawals of retirement funds are a significant benefit for people who need to spend their savings to fund their retirement, but what if you don’t need to access your funds? A Roth conversion can still benefit your situation if you are planning to pass your retirement assets to heirs.
One type of tax-free withdrawal from a Roth retirement account is a distribution due to the death of the account holder. That means your heirs can also enjoy tax-free withdrawals if you leave a Roth account to them. This provision can make a Roth conversion an attractive option if you are planning your estate as well as planning for retirement.
Consider Converting to Roth If You Want to Avoid RMDs
Roth retirement accounts provide the flexibility to withdraw your retirement assets if you need them, but don’t force you to distribute the assets later in life. On the other hand, Traditional retirement accounts are subject to RMDs, which require you to withdraw a certain amount each year after reaching age 70 ½, 72, 73, or 75 depending on your birth year.
If you are seeking more flexibility with your retirement withdrawals, a Roth conversion could provide it. Conversely, if you plan to withdraw from your retirement accounts on a regular basis, RMDs may not be much of a concern to you.
The Downside of a Roth Conversion: Immediate Taxation
While there are many benefits of a Roth retirement plan, the conversion itself comes with one main complication – immediate taxation on the amount you convert. The amount of taxes you owe on a Roth conversion depends on the conversion amount and your effective tax rate.
A conversion can raise your effective tax rate. However, you may be able to avoid this outcome by converting smaller amounts over several years since there is no limit to the number of Roth conversions you can complete in your lifetime.
When the time comes to pay the taxes on your conversion, you have two options. You can have taxes withheld from the conversion and pay a 10% early withdrawal penalty on those funds or cover the taxes from your savings.
While the taxation of a conversion can be a significant hurdle, the benefits of Roth sometimes outweigh the short-term financial pain. This is often the case for people who anticipate high retirement taxes, expect significant investment gains, have a long period of time before they need access to their funds, want to provide tax-free income for heirs, or want to avoid RMDs. However, a conversion is a permanent change. Even if one of these scenarios applies to you, discuss your retirement plan with an experienced financial advisor before committing to a decision that will impact your finances for the rest of your life.
Discuss Your Roth Conversion with Brookstone Wealth Management
At Brookstone Wealth Management, we can help you weigh the costs and benefits of a Roth conversion and make the choice that could provide the greatest benefit for your retirement plan. Our focus on coaching, teaching, and mentoring clients ensures that you feel comfortable and informed throughout this decision as well as the entire retirement planning process.
Retirement planning is just one part of our comprehensive wealth management program, Financial Fingerprint®. This nimble plan brings together the most important aspects of your financial life in one easy-to-understand plan that helps you achieve Financial Navigation Made Simple.
To learn more about Financial Fingerprint® or discuss your personal financial situation, contact a member of our team today.
