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The Pros and Cons of Roth Conversions

Tax Planning

As financial advisors, guiding clients through the complex world of retirement planning is a significant part of our role. One strategy that often comes up in discussions is the Roth conversion. This involves transferring funds from a traditional IRA into a Roth IRA.[1] While the potential benefits are compelling, it is important to weigh them against the possible drawbacks.

Pros of Roth Conversions

1. Tax-Free Withdrawals in Retirement: One of the most attractive features of a Roth IRA is the ability to withdraw funds tax-free during retirement. This can be particularly beneficial for clients who expect to be in a higher tax bracket later in life. By paying taxes on the converted amount now, clients can enjoy tax-free income later, potentially saving a significant amount in taxes over time.

2. No Required Minimum Distributions (RMDs): Traditional IRAs require account holders to start taking RMDs at age 73. Roth IRAs, however, have no such requirement. This allows clients to let their investments grow for a more extended period, which can be advantageous for those who do not need access to their retirement funds.

3. Estate Planning Benefits: Roth IRAs can be an effective tool in estate planning. Since Roth IRAs do not have RMDs, the funds can grow tax-free throughout the account holder’s lifetime and be passed on to heirs. Beneficiaries will also benefit from tax-free withdrawals, which can be a valuable legacy.

4. Potential for Lower Taxes on Social Security Benefits: Withdrawals from traditional IRAs can increase a client’s taxable income, potentially leading to higher taxes on Social Security benefits. Since Roth IRA withdrawals are tax-free, they do not affect the taxable portion of Social Security benefits, which can help clients keep their overall tax liability lower in retirement.

Cons of Roth Conversions

1. Immediate Tax Liability: The most significant downside of a Roth conversion is the immediate tax bill. It’s the stick (taxes) to the carrot (tax-free growth and withdrawals). The converted amount is treated as taxable income in the year the conversion occurs. When we propose Roth conversions to clients, we confirm they have the resources to pay this tax bill without dipping into their retirement savings. We don’t want to withhold taxes on the converted amount; it reduces the amount of money added to the Roth IRA, which is counteractive to the strategy. 

2. Impact on Tax Brackets and Credits: A Roth conversion can push clients into higher tax brackets, potentially affecting their eligibility for certain tax credits and deductions. This can lead to a higher overall tax liability for the year of the conversion. Therefore, careful planning is crucial, and we need to consider the timing and amount of the conversion to minimize this impact.

3. Uncertainty of Future Tax Policies: While current tax laws make Roth conversions an attractive option, future changes in tax policy could alter their benefits. For instance, if future tax rates decrease, the advantage of paying taxes now on converted amounts might be lessened. Conversely, if tax rates increase, the benefits of a Roth conversion could become even more pronounced. Today, marginal tax rates are at historical lows and the likelihood of taxes going lower is low. Therefore, you might want to consider paying the devil you know.

So how do you know if you are a viable candidate for Roth conversions? There is no perfect profile; however, Roth conversions could be a great option for you if you:

  1. Want to leave a valuable legacy to your beneficiaries.
  2. Have the resources to pay the taxes – extra cash.
  3. Do not see taxes going down in your future – whether it’s because of tax laws and policy changes or your income won't be reduced in retirement. 

Thoroughly evaluating these factors in the context of each client’s unique financial situation and long-term goals is essential! By carefully considering the pros and cons, we can help clients decide whether a Roth conversion aligns with your tax, legacy, and retirement planning strategies. Regular reviews and adjustments to financial plans will ensure that clients are well positioned to pursue their retirement goals, regardless of changes in tax laws or economic conditions.

~ Steve Gormley

[1] Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA. (22-LPL)

*A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.