If you’re thinking about converting a traditional IRA to a Roth IRA, it might be a smart move – especially as you assess financial strategies in relation to your wealth and health. But, as with all important financial decisions, there are a few things to consider.
To help shed light on the subject , we spoke with Doug Ewing, a Certified Financial Planner® and director of Advanced Markets with Transamerica.
Time is money
First, Ewing indicates: The more time you have to let a Roth IRA grow, it may make more sense to convert now than it would if you had less time until retirement. With your traditional account, you’ve made tax-deferred — and likely tax-deductible — contributions. Of course, every situation is different and you’ll want to consult qualified tax and financial professionals.
So, in the conversion process, you’re going to have to pay a tax bill. If you’ve got a good amount of money in that account, that’ll be a sizeable bill. But after you’ve paid it, the Roth account will continue to grow tax-free. And as long as you wait five years and you’re 59 ½ or older, you can withdraw the converted amount without a penalty or taxes.
By following that principle, a conversion may make more sense when you’re young. That’s true. If you’re 70 years old and using your IRA for income, a conversion probably doesn’t make sense. But, Ewing points out, just because you’re retired, don’t rule out converting a traditional account.
Sharing the wealth
“It’s sometimes overlooked, but another potential advantage to a Roth conversion is in estate planning and wealth transfer,” Ewing says.
If your goal is to convert it, never touch it (Roth IRAs don’t have required minimum distributions), and then leave it to a beneficiary, this strategy might be worth considering.
Ewing uses this scenario: Let’s say you’re very wealthy with a net worth over $11 million. That means you’ll have exposure to estate taxes. In this example, your beneficiary (an adult child) is also very successful and already in the top tax bracket at 39.6%.
You convert a $1 million traditional IRA and pay $400,000 in income taxes. That may seem like a lot, but stay with us. If you’re able to pay that tax bill from other assets, the full $1 million Roth account remains in tact. You live another 15 years and the account grows to $2 million.
When you die, your beneficiary inherits a $2 million Roth IRA. Then he or she takes required life expectancy distributions for the rest of their life—maybe 30 years or so. We’ll assume your beneficiary only takes minimum distributions (tax-free) and earns another $1 million in growth over those three decades. That’s a $400,000 tax bill on what could ultimately become a $3 million account, and a very competitive 13% tax rate.
If you leave the $1 million traditional IRA (plus $400,000 tax savings) to your beneficiary and the account has similar growth, he or she may net around the same amount. But the beneficiary will pay 40% along the way, or $1.2 million in taxes. Of course, this assumes tax rates on high earners stay the same, which we can’t predict.
Ewing admits it’s not a purely mathematical argument. The net amount left to your beneficiary could end up being about the same. But the Roth conversion strategy could mean prepaying to lock in a smaller tax bill in dollar terms. And it also may protect your beneficiary against the prospect of higher tax rates in the future.
Of course, there are other considerations, and you’ll want to talk with a financial professional to assess your own situation. But Ewing likes to remind people to not rule out a conversion just because they are retired. In the case of estate planning and wealth transfer, it might be a valuable proposition.
Neither Transamerica nor its agents or representatives may provide tax, investment or legal advice. Anyone to whom this material is promoted, marketed, or recommended should consult with and rely on their own independent tax and legal advisors and financial professional regarding their particular situation and the concepts presented herein.