I tell my clients there are six important questions to answer before you can be certain that converting is, or is not in your best interest. The first question is, “what is your ability to pay the taxes due on the conversion?”
When you convert to a ROTH IRA taxes will be owed on any pre-tax contributions and earnings. It is not preferable to pay the conversion tax from an IRA. You lose the potential benefit of tax-free growth.
The next question to chew on is your time horizon. Will you be able to leave the converted funds in the ROTH IRA for at least 5 years? If you convert a traditional IRA or a 401(k) into a ROTH IRA you must wait at least five years or be subject to taxes and possibly a 10% penalty, unless you qualify for certain exceptions. See IRS website:
Next you should consider how important it will be to manage taxable income in retirement. When you take your normal RMD (required minimum distribution) from an IRA you might be bumped into a higher tax bracket at age 70 ½. Converting some of your IRA now will lower the amount of RMDs you must take each year, and potentially lowering your taxable income.
Of equal concern is the impact on your current income tax bracket. Because the amount converted to a ROTH IRA is treated as taxable income, conversion could bump you into a higher tax bracket for the year that you convert. So, depending on how deep into the bracket you are pushed, it could be better to convert only a portion of IRA assets.
For those who do not plan to spend down their IRA in retirement, and anticipate passing wealth on to their heirs, converting to a ROTH IRA could provide a valuable income-tax-free gift to their heirs.
Finally, and arguably the hardest question to answer, in what tax bracket will you be in the future, and do you anticipate being in the higher tax bracket in retirement.
So, does it make sense to convert an IRA or a 401(k) to a ROTH-IRA? Ultimately it depends upon a careful analysis of the above mentioned questions. Whether the answer for you is to convert, or not convert, the decision is an important one to make.
Take a moment to review your personal financial situation using the ROTH Decision Matrix below to help determine what your situation is:
|Consideration||Why it matters|
No ConversionMay make sense
Full conversionMay make sense
Partial ConversionMay make sense
Expected futureTax rate
|Key to your decisions will be your personal view on future tax rates and what you think your tax rate may be in retirement.||Are you expecting to pay a lower rate when you begin to take withdrawals?Yes/No||Do you expect to be taxed at the same or a higher rate when you begin taking withdrawals?Yes/No||Are you unsure about your future tax rate but concerned about protecting assets from future changes in the law?Yes/No|
|Ability to pay taxes from non-IRA account||When you convert to a Roth IRA, you’ll owe taxes on any pre-tax contributions. It is not preferable to pay the conversion tax from an IRA. You could lose the potential benefits of tax-free growth.||Are you unable or unwilling to pay any additional income tax at this point?Yes/No||Are you able to pay all conversion taxes from a non-IRA account?Yes/No||Are you able to pay only some of the taxes from a non-IRA account at this time?Yes/No|
|Time horizon||Funds converted to a Roth IRA must be held in the account for five years or until you turn age 59 ½.||Will you need to access all funds in your traditional IRA in the next five years?Yes/No||Can you do without his/her converted IRA funds in the next five years?Yes/No||Will you need to access some of your IRA funds in the next five years?Yes/No|
|Desire to manage taxable income in retirement||You could be bumped to a higher tax bracket at age 70 ½ when required minimum distributions (RMD) begin for a traditional IRA. Converting some IRA assets to a Roth IRA will lower the amount of RMDs you must take each year, thereby lowering taxable income.||N/A||Do you expect RMDs to significantly impact your tax bracket in retirement or expect RMDs to be a large percentage of total income in retirement?Yes/No||Are you unsure if RMDs will impact your tax bracket in retirement but want the flexibility to manage withdrawals and taxable income?Yes/No|
|Impact on current income tax bracket||Because the amount converted to a Roth IRA is treated as taxable income, conversion could bump you into a higher tax bracket for the year they convert. Depending on how deep into the bracket an individual is pushed, it could be better to convert only a portion of IRA assets.||N/A||Will the conversion have little or no effect on your current income tax bracket?Yes/No||Will the conversion income push you well into a higher tax bracket?Yes/No|
|Estate Planning needs||If you are not planning to spend down an IRA in retirement, and anticipate passing wealth on to heirs, converting to a Roth IRA will reduce taxable estate and provide an income-tax-free gift to heirs and beneficiaries.||N/A||Do you plan to leave wealth to heirs and/or beneficiaries?Yes/No||Do you plan to pass wealth on to beneficiaries but also intend to use some of the funds in retirement?Yes/No|
IMPORTANT DISCLOSURE INFORMATION
The information provided in this article is intended for general information purposes only a d should not be considered personalized tax, legal or estate planning advice. Each investor needs to review his or her retirement plan strategy for his or her particular situation before making any decisions. You should be aware that the rules and restrictions regarding taxes and retirement plans are subject to change without notice. Brendel&Fisher Wealth Management does not provide tax or legal advice. Where specific advice is necessary or appropriate, Brendel&Fisher Wealth Management recommends consultation with a qualified tax advisor, CPA, financial planner or estate planning advisor.