Thinking About Roth Conversions

Pay now or pay later, that’s the main question when we think about taxes on our retirement accounts and it’s one with lasting consequences. A client recently sent me an article about converting traditional IRAs to Roth IRAs in the context of government debt. Let’s touch on that while discussing some of the basic considerations for people who feel they need to play catchup when it comes to Roth accounts.

The history of individual retirement accounts coincides with the decline of employer-sponsored pension plans. I won’t go into all of that here. However, some context is important. The shift began in the 70’s and 80’s to account types that were owned, managed, and the responsibility of employees instead of employers. This led to the 401(k) structure we’re all familiar with and, over time, the expansion of IRAs. To incentivize savings the government gave workers a tax deduction on contributions and the employer got a tax break (and less burden from not having to provide workers with a pension) when it added money to an employee’s account. Employers had rules to follow when structuring plans, but otherwise employees were on their own to manage their 401(k)s if that was an option and, if not, their IRA.

That was (and still is) the primary option for retirement savings until the late-90’s when Roth IRAs were created by Congress. Roth accounts flipped the tax savings thinking around – savers gave up a tax deduction on their contribution but got tax free growth if they left money in the Roth long enough. As with traditional IRAs, Roth accounts weren’t available in the workplace. Instead, savers opened and funded these accounts based on various limitations, such as the original $2,000 maximum annual contribution. This was raised over time to the current $7,000, or $8,000 for those age 50 or older.

Decades of inertia around this led to most savers having most of their money in tax-deferred 401(k) accounts and IRAs instead of in a Roth. Any dollar saved for retirement is positive, but the long-term reliance on traditional plans leaves many savers facing a series of tax bills because every dollar in those accounts will be taxed as ordinary income when withdrawn.

Say you contributed $100,000 during your working years and your balance grew to $1 million. Nice job! You saved on taxes while saving for retirement and haven’t paid taxes on dividends, interest, and gains in your account the whole time. The US Treasury has been waiting decades for tax revenue and they’ll eventually get it. Part of how they collect is by requiring you to start taking distributions by age 73 whether you need the money or not. Most retirees would have already started taking distributions for obvious reasons, but many don’t. These latter folks are left paying taxes on income they don’t actually need. On a million-dollar balance the first required distribution could be $38,000, all taxable in the year distributed. That could kick the account owner into a higher tax bracket or more if this income coincides with a spouse’s distribution, Social Security income, and so forth. Too much taxable income is a good problem to have but it’s still a problem.

It’s this group that Roths appeal to most in hindsight since Roth IRAs don’t have the minimum distribution requirement. The challenge is how to get money that’s currently in a traditional retirement account into a Roth.

This is where Roth Conversions come in. You do this by having your existing custodian (your workplace plan or brokerage firm) move cash and/or investments from your traditional balance into Roth. Sounds straightforward, right? There might be some forms but otherwise it’s all electronic and shouldn’t cost anything… in fees. However, the conversion gets taxed as income during the year you convert. You have the option to withhold taxes at the time, but generally speaking it’s better to pay at tax-time with other money (doing so helps the Roth conversion break even faster). The ultimate tax bill depends on a variety of factors that are beyond the scope of this post, but your tax advisor or humble financial planner can help you figure this out.

So planning ahead to reduce the impact of required distributions makes good sense depending on your current tax situation. But what if taxes are higher in the future, and should you try to preempt that by converting more now? Aren’t higher taxes a given with government debt being so high?

Our national debt is massive, more than twice that of any other country and larger than the next four higher-debt country’s debt load combined, according to a quick Google search. That sounds bad. However, we should remember that our economy is equally massive and our nation’s debt functions differently than our personal household debt does. To grossly oversimplify, our government can continue to refinance its debt indefinitely so long as there are willing lenders. And willing lenders abound. Our bonds are the most liquid in the world and our currency is involved in an overwhelming majority of all foreign exchange transactions. Sure, there may come a time when our economic status and currency is meaningfully different, but that’s not likely anytime soon.

Ensuring long-term dollar primacy requires that we keep our fiscal house in order. However, it doesn’t necessarily matter in the way many in the marketplace use to scare (for lack of a better word) people into buying a product or books about investing in gold or paying abnormally high tax bills when converting traditional retirement account balances into a Roth.

So consider your motivation for doing a Roth conversion and make sure it makes sense for your personal situation. Run some tax projections while weighing other options for shielding your IRA from taxes, such as donating money from your IRA to charity tax-free if you’re at least 70.5 years old. This can be a good way to offset taxes on required minimum distributions while helping the organizations you value. Beyond that, be careful about how quickly you try to play catchup with the perceived benefits of a Roth IRA. 

Have questions? Ask us. We can help.