Roth Conversions

Roth vs. traditional is a time-old debate (at least since the 80’s and 90’s when Roth was proposed).   Truth is, when planning for retirement, it’s good to have several different tax buckets to withdraw from.

The big three buckets:

• Tax-deferred: this would be your employer retirement account (in most cases) or traditional IRA’s, maybe even some annuities.
• Taxable: this refers to a taxable investment account that you pay taxes on annually as you recognize appreciation and things like interest and dividends.
• Tax-free: this is the Roth IRA (or Roth portion of your retirement account).  Your contributions were taxed the year you earned the money, but then all the subsequent investment growth can be withdrawn later completely tax-free.  Some goal-specific accounts can also be managed this way, such as 529 accounts for education or Health Savings Accounts, as long as they’re spent on qualifying expenses.

Since the term ‘tax-free’ is the IRS’s worst nightmare, there are limitations on Roth varieties of accounts, such as how much income you can make and how much you can contribute per year.  This is why many of our clients end up without a tax-free Roth bucket in their retirement strategy, and why we recommend Roth conversions.

The earlier you convert all or part of your tax-deferred bucket to Roth, the longer the investment has to grow before being withdrawn tax-free.  You do have to recognize income equal to the amount you’re converting in the year you convert it, which means a year you earn less income on paper or have no income because you just retired may be the perfect time to convert and still effectively manage the tax bill.

Besides growing and being withdrawn tax-free, the Roth account is also tax free to your beneficiaries if you were to pass before spending all of your money.  There are also no required minimum distributions for either you or your beneficiaries – another distinguishing factor from traditional tax-deferred accounts.

Here are a couple conclusions from a Vanguard study on how to best approach Roth conversions:

• Even if you expect your tax brackets to be higher now and lower in retirement, there is a calculable break even point where a Roth conversion will still benefit you.
• Pay the tax bill for a conversion out of pocket or from a taxable account – not from the balance you’re moving from traditional to Roth.

(NOTE: Some of you may be thinking, what about the back-door Roth strategy?  This only works if you 1. Have employment income, and 2. Don’t have any money in traditional IRA accounts.)