Q: I am 85 years old and would like to know if I should convert my IRAs to Roths to preserve my lifetime of saving from higher tax rates in the future.
A: A traditional IRA is funded with pretax dollars. You pay your regular income tax rate when you withdraw the money in retirement and without penalty after age 59½. Contributions into a Roth IRA are with after-tax dollars. The money taken out during retirement is tax free, assuming you have had the Roth for at least five years and you are 59½ or older. With a conversion you transfer money from your tax-sheltered traditional IRA, pay income taxes owed and put the money into a Roth. An additional advantage to a Roth is there isn’t any required minimum distributions (RMD) unlike with traditional IRAs and 401(k)s. (The pandemic-driven CARES Act suspended RMD rules for 2020.)
Question is, is it worth paying taxes now on the withdrawn money to make the conversion and enjoy tax-free withdrawals later? Your individual details matter greatly, but odds are conversion may not be the best plan.
Conversions don’t make sense if you don’t have additional savings to pay the tax levy.
“In the year of a Roth IRA conversion, the full amount of the withdrawal is included in taxable income and a large conversion can easily push someone from a lower tax bracket into the highest tax bracket. The break-even point on paying significant taxes can take years or even decades to reach,” said Dan Stolfa, managing director, wealth and fiduciary adviser at Evercore Wealth Management. “If that tax burden is paid from IRA assets, it will take even longer.”
Do you believe your marginal tax rate in the future will be higher than it is currently? If your answer is yes, a conversion becomes more attractive and if no, it’s best to stick with the traditional IRA.
Time is the third critical consideration. “Another issue, and one that seems important in this case, is that conversions into Roth IRAs are still subject to the five-year rule,” said Stolfa. “Lyn would have to wait for five years after the conversion to begin taking tax-free withdrawals.”
Despite legislative changes, the Roth is attractive for relatively young people and as an estate planning tool for philanthropic and wealth transfers. “For most people like Lyn who are past RMD age and are using IRA assets to fund living expenses, large-scale conversions don’t make sense,” says Stolfa — an observation subject to the vagaries of individual circumstances, he added.
Chris Farrell is senior economics contributor, “Marketplace” and Minnesota Public Radio.