Anyone with a traditional, tax-deferred IRA can convert it to a tax-free Roth IRA. The question is: should you?
The answer is: there is no easy answer.
With a Roth IRA, you do indeed receive your funds tax-free at retirement. But that’s only because you pay taxes on them at the time you complete the conversion. Whether you’ll end up with a smaller tax bill by paying now or later depends on your circumstances and how tax law may or may not change in the years ahead.
Here are a few things to consider before making a change:
- Can you afford the tax payment now? If you need to tap into your retirement funds to pay the tax bill for your Roth conversion, you may want to think twice. Reducing the size of your retirement account now may hurt you more than the tax benefits will help later. The larger the conversion and the higher your tax bracket, the greater the tax consequences will be.
- When do you plan to retire? Longer timeframes tend to favor conversion. If you plan to retire in the next few years, your Roth IRA may not earn enough to justify the cost of your early tax bill. If your retirement is 20 or more years away, however, the power of compounding tax-free generally starts to make the conversion worthwhile.
- How might tax rates change in the future? We are in a historically low income tax environment. If tax rates go up, the cost of conversion will increase as well. In that case, converting to a Roth IRA now could be a good move for many people, but not everyone. For example, if you’re in your prime earning years today and expect your tax rate to go down dramatically in retirement, it might be smarter to hold off until you hit those low tax years.
- Is your balance sheet dominated by tax-deferred accounts? Many people accumulate the bulk of their retirement money in tax-deferred plans. If that is true for you, a Roth conversion might give you some flexibility down the road, allowing you to meet your lifestyle or estate planning objectives without triggering income taxes with every withdrawal. Because you don’t know how the tax structure might change over time, it’s also a good idea to build some tax diversification into your retirement accounts.
- Are you interested in a tax-free gift for your heirs? Roth IRAs can be maintained and passed on to your heirs, who can withdraw funds over their lifetime without paying any additional income taxes. You, in other words, can give them a gift of tax-free future growth. How valuable that gift becomes depends on how long the account is allowed to grow in your hands and theirs.
The bottom line: there are benefits—and risks—with whichever IRA route you choose. Your financial advisor can help you choose the alternative that best meets your needs. Always consult your tax advisor before investing. iBi