A ROTH conversion involves liquidating assets inside a tax-deferred (tax-advantaged) account like a traditional IRA, or conducting an in-kind transfer of held assets, paying income taxes on the intended withdrawal, and then funding a ROTH IRA account with the cash proceeds.
The ROTH IRA offers these benefits:
- Investors don’t pay income taxed on future withdrawals
- There are no minimum required distributions (RMDs) on ROTH IRA accounts, as there are for traditional IRAs and 401(k)s.
- ROTH IRA assets can pass on tax-free to heirs (other IRA withdrawal rules apply)
When would a ROTH conversion make the most sense?
- When asset positions in an IRA have fallen a sizable amount due to negative market performance bringing the account value down a good bit
- When the account size is modest, yet holds an investment that has enormous potential for capital appreciation.
- Those who have come into a sizable inheritance and have much excess cash available to cover the tax liability.
- Those who are just entering retirement, because they typically don’t have much in the form of taxable income during the first few years.
- When cash needs for the first several years for early retirees are already in place.
- When early retirees have pushed back claiming Social Security benefits.
- When early retirees are years away from having to begin taking withdrawals from their IRA to meet their monthly income needs.
Who would stand to benefit the least from a ROTH conversion?
- Persons still gainfully employed and their income places them in a high tax bracket. A conversion can easily throw them into a higher tax bracket. The higher the “taxable income” the more dollars paid to the IRS.
- Persons who are advised to split the conversion over two or more calendar years for the purpose of making the tax liability more manageable; and are unable to project having the excess cash to cover future tax liability.
- Persons who are fearful of political party produced tax increases.
- Investors with modest IRA account sizes will benefit little from ROTH conversions as they will probably be using the funds for themselves as opposed to passing them on to heirs.
- Persons who do not have extra cash* sitting aside to cover the tax liability resulting from a conversion. *Emergency reserve is fully funded, retirement accounts are being fully funded, HSA accounts fully funded, projected household repairs fully funded.
