Roth conversions are a common topic of conversation between financial advisors and clients who have IRAs. One of the goals of optimizing tax planning is to pay taxes whenever rates are lower. However, just as it isn’t always easy to predict when to buy low or sell high, choosing the ideal time to convert to a Roth IRA can be a challenge.
The reason is most clients can’t accurately predict their tax bracket during retirement. While people often end up in a lower tax bracket after retiring, that shift isn’t guaranteed. When doing a Roth conversion from a traditional IRA, taxes are paid before they’re legally required.. Since advisors are generally in the practice of deferring taxes, any action that means paying taxes early is not something they want to do.
Estimating the future tax rate of a client can be an uphill battle. As a result, it’s generally worthwhile for advisors to focus their attention and client conversations on a few other reasons. Let’s take a look at some of these reasons.
Diversifying Tax Risk
Diversification isn’t a principle that only applies to investing. It also plays an important role in tax planning. An optimal strategy is to have a mix of funds that are tax-free, tax-deferred, and taxable, and within the taxable accounts to have some funds invested to generate ordinary income and others that will produce capital gains. The role a Roth conversion plays in tax-risk diversification is filling up the tax-free basket as a hedge against potentially costly future tax increases.
This also brings up an important point to communicate with clients, which is that this conversion isn’t an all-or-nothing choice. Instead, the best option may be to do a partial conversion or systematic partial Roth conversions over multiple years to keep income in a lower bracket while still converting something on an annual basis. This will make Roth funds more valuable in the event tax rates do increase.
Eliminating Required Minimum Distributions
Roth IRAs are not subject to lifetime required minimum distributions (RMDs). After the tax is paid during conversion, Roth funds normally become tax-free. This is true even for beneficiaries (although beneficiaries are subject to RMDs). Since many clients want full control over their retirement distributions, converting to eliminate required minimum distributions can be a compelling option for clients.
Insurance Against Higher Tax Rates
Another tax benefit of a Roth conversion is being able to insure against higher tax rates in the future. Although those rates are unknown, this conversion can provide clients with a great sense of certainty during retirement. Because there is an opportunity cost associated with this conversion, it’s important for advisors to help clients choose the optimal time to take this action.