Tax-deferred investment growth, tax-free distributions. These are the defining characteristics of Roth IRAs, which make them highly attractive investment vehicles. For high-net-worth individuals and families, however, there’s a problem: accessibility. Roth IRAs have low annual contribution limits and income rules limiting who can contribute, which effectively takes them off the financial planning table for many.

But that’s where Roth IRA conversions come in.

This article will explain what Roth IRA conversions are, how they work and key considerations for deciding whether a Roth conversion makes sense for your family’s financial future.

First, the basics. A Roth IRA conversion is the process of transferring funds from a pre-tax retirement account (traditional IRA, rollover IRA, SIMPLE IRA, etc.) into a Roth IRA. Since money is moving from a tax-deferred account to a tax-free account, the amount converted is added to your taxable income for the year—which means owing taxes on the ‘converted amount’ at ordinary income tax rates. To make that point clear, the tax bill is due in the year you perform the conversion, not later when you or future generations withdraw the funds.

The immediate tax impact that comes with Roth conversions is sometimes enough to discourage investors from moving forward. But it’s important to weigh the tax cost against the full range of benefits that Roth conversions offer.

The first benefit is tax-free growth and tax-free distributions after a five-year waiting period (assuming the owner is at or over retirement age). There are also no Required Minimum Distribution (RMD) rules associated with Roth IRAs, which can allow the funds to continue growing tax-free for a longer period. The combination of these two benefits—tax-free distributions and no RMD requirements—creates a greater level of flexibility in retirement planning, particularly as it relates to tax mitigation strategies and income planning.

The estate planning/wealth transfer benefits of Roth conversions are also evident. In short, paying taxes on the assets now means beneficiaries won’t have to later, which effectively shifts the tax burden forward in time. Income tax rates fluctuate over time, of course, and there’s no way to know whether they will be higher or lower in the future. But the United States’ growing debt burden suggests that tax rates cannot move lower without significant reductions in spending, a feat that has alluded various administrations for decades.

There are also some drawbacks of Roth conversions to keep in mind, the main one being the immediate and often sizable tax liability. For individuals who convert a large amount, it could mean bumping into a higher tax bracket and owing significant taxes in the conversion year. The increased income from the conversion could affect your eligibility for certain tax credits, deductions and benefits, such as Medicare premiums, which are income-dependent. This is a key area where high-net-worth families should consult tax advisors and financial planners about the timing and size of conversions, perhaps exploring the idea of doing partial conversions over many years. Since the IRS does not limit the number of Roth conversions a person can do, this type of strategy could make sense in unique situations.

Time can also be a drawback for some. I’ve established that doing a Roth conversion means footing a significant tax bill, which also suggests that an investor should have a reasonably long time horizon where the assets can grow and essentially ‘recoup’ the money paid in taxes. This brings up another important consideration and potential drawback of Roth conversions: the 5-year rule.

Once funds are converted from a Traditional IRA to a Roth IRA, the account owner must wait five years before withdrawing any converted funds tax-free and penalty-free, regardless of age. This rule applies to each conversion separately, meaning that multiple conversions over different years will also have multiple 5-year waiting periods. Violating this rule means losing tax-free withdrawals, which essentially defeats the purpose of the conversion.

To give an example of when a Roth conversion could be beneficial, consider a scenario where a family expects higher tax rates in the future, perhaps due to Required Minimum Distributions, a higher salary, more passive income from rental properties, the sale of a business, etc. In this scenario, initiating a Roth conversion before the onset of higher tax rates could make sense, so the converted amount will be taxed at a lower rate.

The flip side of this scenario would be a family currently in the highest tax bracket but is expecting to pay lower tax rates in the future, perhaps due to retirement and cash flows generated via municipal bonds and capital gains. Waiting could make sense in this case, and perhaps doing partial conversions over time to spread out the tax liability and avoid moving too far up in tax brackets in any single year.

Hopefully, it’s clear that while there are many benefits and advantages to Roth IRA conversions—chief among them tax-deferred growth, tax-free withdrawals and no RMDS—there are also many key considerations, strategies and individual circumstances that investors need to keep in mind before proceeding. In other words, there are right ways and wrong ways to go about doing Roth conversions.

Consulting with a financial advisor and likely a tax professional can help a family determine if a Roth conversion makes sense for their specific situation. In fact, this should be the first step.

 

IMPORTANT DISCLOSURES

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. In addition, information presented in this presentation is believed to be factual and up to date, but Newport Capital Group, LLC does not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. 

This presentation includes forward-looking statements and opinions, including descriptions of anticipated market changes and expectations of future activity. Forward-looking statements and opinions are inherently uncertain, and actual events or results may differ materially from those reflected in the forward-looking statements. In addition, all expressions of opinion are subject to change without notice in reaction to shifting market conditions. Therefore, undue reliance should not be placed on such forward-looking statements and opinions.

The tax and estate planning information offered by Newport Capital Group 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.

Past performance is no guarantee of future performance.