Believe it or not, the average Baby Boomer is now 71 years old. That means many are approaching the age when required minimum distributions (RMDs) begin. Perhaps this is why there has been an aggressive industry-wide push encouraging seniors to convert their traditional 401(k)s and IRAs into Roth accounts. Driven by financial media and advisors, Roth conversions are often marketed as a great way of keeping more of your money out of the IRS’s hands. But are they really the one-size-fits-all solution they are portrayed to be?
Roth conversions can absolutely be valuable in the right circumstances. However, their benefits depend heavily on when the conversion is done, what your current income is and what you expect it to be in the future, and what your estate planning goals are.
Let’s start with the potential advantages. One of the most significant benefits is reducing future RMDs, which can help retirees better control their taxable income later in life. Conversions can be particularly attractive during lower-income years, such as the period between retirement and the start of Social Security benefits, allowing retirees to move money into a Roth when sitting in a lower bracket. Maintaining assets in both traditional and Roth accounts also provides valuable tax diversification and greater flexibility when managing income, taxes, and unexpected expenses.
In addition, because Roth accounts can generally be inherited tax-free, they may also provide a more efficient legacy for beneficiaries, particularly those who themselves are in higher tax brackets. Finally, converting funds now can serve as a hedge against potential tax increases in the future by locking in current tax rates on a portion of the retirement assets.
While these advantages can be compelling, their value depends entirely on an individual’s circumstances. In fact, there are many situations where a Roth conversion can actually be harmful.
One of the most common pitfalls is triggering higher Medicare premiums through IRMAA surcharges, since conversion income can significantly increase a retiree’s reported income. Conversions can also result in paying taxes at higher rates than would have applied later. For example, individuals who expect to move to a lower-tax state in retirement or have a lower income in their later years may end up paying more in taxes than they would have had they not converted.
Roth conversions may also be less attractive for retirees who intend to be generous to charitable organizations. Donations from traditional IRAs can often satisfy RMD requirements while avoiding income taxation altogether, reducing the potential benefit of a conversion.
Perhaps the biggest misconception about Roth conversions is the belief that they automatically create additional wealth because all future growth is received tax-free. While tax-free growth sounds powerful, investors often forget that a portion of their account was sacrificed upfront to pay the conversion tax.
This may appear counterintuitive, but if your tax rate remains the same from the time of conversion through the end of your life, the math works out exactly the same whether your money remains in a traditional IRA or is converted to a Roth. In other words, a conversion does not magically reduce taxes; it merely changes when they are paid.
Roth conversions are not necessarily good or bad. They are just one planning tool among many. Before converting, investors should look beyond the marketing headlines and ask one simple question: Am I paying taxes at a lower rate today than I am likely to pay in the future? If the answer is yes, a Roth conversion may make sense. If not, it may simply be an exercise in paying taxes sooner.
(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations)