For the sake of brevity, I will not dive into the details of why having a certain percentage of your assets within a tax-free vehicle (like a Roth IRA or Health Savings Account) is important nor will I talk about the general benefits of a Roth IRA. My focus today will be on when Roth Conversions should be considered.
In my opinion, there are five obvious types of people who should at least consider converting a portion of their Traditional IRA (or 401(k)) assets to a Roth IRA:
- Recent retirees who have not yet reached age 70.5
- Millennials or Gen Y’ers who have recently changed jobs
- Individuals in poor health who face a looming estate tax bill
- Families who plan to leave IRA assets as a legacy to heirs
- Working individuals with abnormally low taxable income for one year
The years between retirement and achieving age 70.5 when Required Minimum Distributions (RMDs) kick in are arguably the best time to consider a Roth Conversion. Typically, your income goes from something to nothing, as you are no longer working. You’ll want to take advantage of this period to do some ‘tax-smoothing’, meaning smoothing out your tax bracket NOW for the years after 70.5. It may be smart to incur some taxes now to ‘fill up’ the 10%, 15%, or 25% tax brackets (or higher based on the size of your tax-deferred assets), so you do not have such a large RMD and tax hit when age 70.5 rolls around. The idea is that you pay more taxes early in retirement, but the amount you pay in taxes over your lifetime is much lower.
One note: Medicare premiums are calculated based on the prior two years of income. The amount converted in a given year is viewed as ordinary income in that year, which could have an adverse effect on your monthly Medicare premium. I suggest working with a trusted professional who can help weigh the plusses and minuses.
Millennials or Gen Y’ers who have recently changed jobs
You are still early in your career, and far from your peak earning years. If you switch jobs, what do you do with your old 401(k) balance? You could easily roll it into your new employer's 401(k) or you could convert the balance to a Roth IRA. By paying a tax upon rollover into a Roth IRA, this would allow for all growth and earnings in this account to grow tax-free for a long period of time (perhaps 40-50+ years). A $25,000 Roth IRA account that grows at 8% per year would be equal to $543,000 in 40 years or $1,172,000 in 50 years. Be sure to have enough cash on hand to pay for the associated taxes (as the converted amount is always viewed as ordinary income), but as you can see, the future payoff could be significant.
Individuals in poor health who face a looming estate tax bill
For 2017, the estate and gift tax exemption per individual is $5.49 million. That means that an individual can leave $5.49 million to one’s heirs without paying a federal estate or gift tax, which is currently set at 40%. If married, that exemption rises to $10.98 million. For simplicity’s sake, let’s assume Bob is single, has a net worth of $6 million, and expects to live just another six months. If Bob were to pass away tomorrow, his estate would have to pay tax on $510,000, as $5.49 million is passed to his heirs tax free. In this case, that remaining $510,000 would be taxed at 40%, requiring a $204,000 tax payment to the government. Bob could take this opportunity to do a Roth Conversion to minimize his tax bill.
He could pay tax now to convert all or a portion of his IRA balance to Roth. This would shrink (or potentially eliminate) his estate tax bill as he would pay taxes now (as each tax bracket is less than 40%). It would also allow for his heirs to continue to see tax-free growth of these assets over their lifetimes, though they are still subject to annual Required Minimum Distributions.
Families who plan to leave IRA assets as a legacy to heirs
Similar to the last group, families or individuals who do not foresee tapping into all of their IRA assets, may decide now is a good time to pursue a Roth Conversion. Here’s why: Your heirs have many more years of tax-free growth (than you), as Roth IRAs do not require withdrawals until after the death of the owner. At this point, the annual withdrawal requirements are based on your heir’s life expectancy.
Working individuals with abnormally low taxable income for one year
The last group who would benefit from executing a Roth Conversion is an individual who has an abnormally low income in a given year. Similar to the Recent Retires group previously noted, this person may benefit from tax smoothing or filling up the lower income tax brackets now before they rise with higher income in the future. Business owners tend to have the most flexibility with their incomes year to year, and should consider this option.
There are many rules and nuances surrounding Roth Conversions (e.g. aggregation rules associated with nondeductible contributions, backdoor Roth possibilities, and recharacterizations), so I urge you to speak with a CFP® or tax professional before proceeding on your own. It is a powerful tool that should be considered within most clients’ financial plan.
Thank you for reading, and please reach out with any questions!