Small Steps Create Big Shifts
While relatively few people have workplace savings plans that allow them to take advantage of a Mega Backdoor Roth, a lot more people are able to consider the potential benefits of a Roth conversion. But, what are those considerations?
There are a lot of important considerations to weigh before doing a Roth conversion. As a result of the current market condition and changes due to the SECURE Act, Roth conversions are becoming an important strategy to discuss with your advisor. This flowchart summarizes some of the major decision points summarized within this article. Here at Hoeven Wealth, we review for Roth conversion appropriateness annually as part of our first and fourth quarter annual service calendar review.
Is a Roth Conversion Right for You?
One of the most common questions we hear from clients concerns Roth conversions: converting traditional IRA or 401(k) assets into a Roth IRA. While this strategy can be powerful, it's not right for everyone. Understanding when a conversion makes sense requires careful consideration of your unique financial situation.
The Core Trade-Off
At its heart, a Roth conversion involves paying taxes today in exchange for tax-free growth and distributions tomorrow. You'll recognize ordinary income in the year you convert, but once the money is in a Roth IRA, it grows tax-free and can be withdrawn tax-free in retirement (subject to certain rules). So, when do conversions tend to make the most sense?
Future Tax Rate Expectations
The most compelling reason to convert is when you expect to be in the same or higher tax bracket during retirement. If tax rates rise, whether due to your income level or tax reform, paying taxes today at a lower rate can be advantageous.
Estate Planning Benefits
If your beneficiaries will be subject to high income tax rates, leaving them Roth assets can be particularly valuable. This is especially true for non-eligible designated beneficiaries who must distribute inherited retirement accounts within 10 years. Tax-free Roth distributions give them more flexibility and keep more money in the family.
You Don't Need Immediate Access
Roth conversions work best when you don't need the converted funds right away. If you'll need distributions within five years of converting, you may face penalties. Additionally, if you won't need retirement account distributions to fund your lifestyle, converting allows the assets to grow tax-free without required minimum distributions (RMDs).
You Can Pay Taxes from Outside Accounts
Ideally, you should have cash outside your retirement accounts to pay the conversion taxes. Using funds from the conversion itself to pay taxes triggers a 10% penalty on that portion (unless you qualify for an exception) and reduces the amount working for you tax-free.
Strategic Timing Opportunities
Certain situations can make Roth conversions particularly attractive:
Market downturns: Converting when asset values are temporarily depressed means you'll pay less in taxes and enjoy more tax-free growth on the recovery
Low-income years: Years with lower than usual income (perhaps between retirement and taking Social Security) create opportunities to convert at favorable rates
Expiring tax benefits: Carryforward losses or tax credits can help offset conversion income
The Bottom Line
Roth conversions are a nuanced strategy that depends heavily on your specific circumstances. There's rarely a one-size-fits-all answer. The decision should account for your current and projected tax rates, retirement income needs, estate planning goals, and the financial situation of your beneficiaries. At Hoeven Wealth, we help clients navigate these decisions by modeling various scenarios and considering all the factors that make your situation unique. If you're wondering whether a Roth conversion makes sense for you, we're here to walk through the analysis together.
Disclosure:
The information presented in this article and flowchart is intended for general educational purposes and should not be interpreted as individualized financial, investment, tax, or legal advice. Any hypothetical examples, scenarios, or illustrative anecdotes are used strictly to demonstrate financial planning concepts and do not reflect all client results. Because each person’s financial situation is unique, the strategies or ideas discussed may not be appropriate for your circumstances. As an investment adviser representative of a registered investment adviser, we act in a fiduciary capacity and provide advice tailored to each client’s objectives only after adequate understanding of the client’s situation. Before making any financial decisions, please consult with your adviser or another qualified professional.
Neither Hoeven Wealth nor XY Investment Solutions provide tax or legal advice. The tax and estate planning information offered is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
