Although Roth IRA conversions are popular, there are a few key things to consider before moving forward. Here are the five considerations I found that need consideration:
- Your tax bracket during retirement. These days it's not unusual for retirees to be in a higher tax bracket during retirement. However, many of us have the option of investing in a Roth IRA, which doesn't offer an up-front tax break—but lets you withdraw funds in retirement tax-free. If you think you are going to be in a higher tax bracket when you retire, you might consider converting some or all of your retirement savings to a Roth before you retire. Converting some or all of your traditional IRA money to a Roth IRA will also give you some tax diversification in retirement to hedge against future changes in tax rates and related rules.
- Benefits for Estate Planning. One of the great things about a Roth IRA is that it isn't subject to required minimum distributions (RMDs) at age 70½, unlike a traditional IRA, where you must withdraw an IRS-mandated amount annually at that age. Plus, it's subject to income taxes. Roth IRAs can continue to grow tax-free for as long as you live, and if your beneficiary is your spouse, he or she can roll over the account and make the Roth IRA his or her own with the same rules (non-spousal beneficiaries are subject to an RMD, but that distribution isn't taxed). In addition, non-spousal beneficiaries can take the RMDs over their entire life expectancy. This is a terrific benefit for younger beneficiaries like children or grandchildren.
- Brace yourself for the tax hit. The big minus for a Roth IRA conversion is that any funds you convert will be subject to income tax in the year of the conversion. That means folks should consider whether they can cover the tax bill and generate enough investment growth to offset the impact. Plus, there may be other considerations—like estate planning—that become more important than "payback" concerns.
- Remember Financial Aid. If you have college-age children who will be applying for FAFSA (Federal Student Aid), you may want to avoid Roth conversions as the calculation for their aid is being made. The extra taxable income these conversions reflect on our tax return could very likely affect their eligibility or the amount of aid.
- Beware a Volatile Stock market. Maybe the only time we'll celebrate a drop in the stock market is when we are trying to convert a traditional IRA to a Roth IRA. With the drop in value in our IRA as we convert we'll get more bang for our buck. We'll be converting a lower amount and paying less in taxes. If you're thinking about rolling over your traditional IRA, consider taking advantage of the stock market correction by converting a larger portion of your traditional account – think of it as "buying low and selling high."
Converting your traditional IRA to a Roth IRA is a powerful tool that can provide financial planning options for many. But before you make a Roth conversion, consider the pros and the cons. We are here to help you with that. Schedule a complimentary consultation with our office today.
Reference: Motley Fool (February 27, 2016) "5 Things to Consider Before Making a Roth IRA Conversion"