By Mallon FitzPatrick, CFP
April 27, 2022 – If clients know one thing about the difference between a traditional individual retirement account (IRA) and a Roth IRA, it’s typically that the former enables “tax-deferred” contributions while the latter is designed for “after-tax” contributions.
Simply put, if you believe your income tax rate is going to decrease, a traditional IRA makes sense, while a Roth IRA may be a better option if you believe it will increase. The goal is to take deductions at a higher rate and distributions at a lower one.
So, if you’re considering converting your IRA to a Roth, you may think this exceedingly straightforward calculation is all you need to decide whether it’s the right choice for you. Determining whether a conversion is optimal, however, is far more complicated than most people realize. Suitability does not hinge on one key factor but rather on a multitude of shifting variables that must be considered in combination with other shifting variables, all of which collectively have no clear outcome.
The rules associated with these vehicles can be complex. Projecting long-term tax rates and other circumstances may prove a futile exercise. Your returns are unpredictable. Tax policies and regulations change. Unexpected life events can throw off any projection. And time spans for any given variable are rarely concrete. So, instead of relying on many calculations and assumptions to determine whether to convert, it’s better to think more strategically about your financial needs, preferences, and wealth transfer goals.
The ABCs of IRA and Roths
You may have a retirement account, such as a 401(k), which is funded by contributions from you and your employer. When retiring or ending employment, you may roll the employer-sponsored retirement account into another one, or an IRA held at the custodian. Typically, most employer retirement assets end up in an IRA. If your contributions are tax-deductible, you have a “pre-tax” account with income that will eventually need to be taxed.
With pre-tax retirement accounts, your assets grow tax-free. Your withdrawals or distributions, however, are treated as ordinary income and taxed. Additionally, at 72, the required minimum distributions (RMD) age as of the release of this article, you must take an annual distribution based on the value of the account and your life expectancy. These RMD, implemented to ensure the IRS receives tax revenue, limit the amount and time assets can grow tax-deferred, and increase one’s income. The additional income may increase Medicare premiums.
With a Roth retirement account, taxed or “post-tax,” money grows tax-free. Withdrawals are non-taxable and there is no requirement to take them. Keeping more assets within the Roth allows them to compound faster than if a RMD was taken. The Roth may also offer a source of funds to help maintain or reduce Medicare premiums. With a Roth, there is no ambiguity with future taxes: What you see is what you get. Note that when converting IRA assets to Roth, either in a lump sum or partially over multiple years, the amount is considered ordinary income and taxable.
To convert or not to convert?
There are a few reasons why now a good time is to consider a Roth conversion. For one, barring any changes from the current administration, many will be hit with higher income tax rates in 2025 when the Tax Cuts and Jobs Act (TCJA) expires. Those in the highest tax bracket will see their rate increase from 37% to 39.6%.
Additionally, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which changed requirements for IRAs, has been undergoing a legislative upgrade. With the proposed regulation, dubbed SECURE Act 2.0, the RMD age would increase to 73 next year, 74 in 2030, and 75 in 2033.
These changes may create a longer runway for a Roth conversion. If you retire, for instance, at 65, and your RMD age is 74, you have 9 years where your income and tax rates are likely relatively low, an ideal condition for conversion. But this runway may be less advantageous if tax rates increase significantly as is currently expected in 2026.
Also, the IRS proposed new regulations for inherited IRAs distributions that are expected to take effect in 2023. The new rules require most non-spouse beneficiaries who inherited an IRA from someone taking RMD to take RMD for ten years. The beneficiary could no longer wait until the 10th year to take the first distribution—a RMD must be taken annually, and the account depleted by the end of the 10th year. These new RMD rules do not impact inherited Roth IRAs and the beneficiary may allow the assets to go tax-free for 10 years. Another variable to consider is the future tax rate of the inheritor – will it be lower, the same, or more?
Benefits in the eye of the beholder
It was the author of the well-known personal finance book, “Rich Dad Poor Dad,” Robert Kiyosaki, who said, “It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” It is a lesson that is particularly relevant here.
It’s true you could run projections based on your current and predicted future tax circumstances and decide whether a conversion is best for you and potentially your heirs. But, considering the complex matrix of variables associated with IRAs, you’re likely to reach a better outcome with a more philosophical approach.
With this strategy, we can review your needs and lifestyle preferences to identify your priorities when it comes to retirement accounts, asking, for instance: Will you need your RMDs to fund your lifestyle, or can you draw from other income or assets? If you do not need your RMDs, you could this portion of your assets grow tax-free and pass them to your heirs in the form of a tax-free Roth.
We might also ask: Do you believe tax rates will increase, decrease, or hold steady over time? Wealth planners tend to be conservative here, working under the assumption that rates will hold steady or increase, accounting for inflation. Taxes will need to be paid one way or another. From a strictly tax perspective, are you a “pre-tax” of “after-tax” person? Does it make sense to pay taxes now and let the assets grow tax-free?
And, considering IRAs and Roths cannot be removed from your estate during your lifetime, it’s important to ask, which account would you prefer to pass on to your heirs? An IRA may require distributions of taxable income to an heir for 10 consecutive years after your death. On the other hand, you could pay taxes now and pass on a non-taxable Roth that has 10 years of tax-free growth before it’s required to distribute.
We can run simulations to project how your tax status might evolve. But they will have limited value. Given the near- and long-term tax and regulatory uncertainty, it may be wise to lock in a Roth. You shouldn’t, however, make a rash decision—take time to understand your financial circumstances and identify your goals. That way, a quantitative analysis will be more meaningful and you’re more likely to feel happy with your decision.