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When Roth Conversions Do (and Don't) Make Sense

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I recently visited Vanguard, where I sat down with Maria Bruno, a senior investment analyst in the firm's investment strategy group. We discussed converting traditional IRA assets to Roth.

Benz: Maria, thank you so much for being here.

Maria Bruno: Thank you, Christine.

Benz: Let's start by looking at Roth conversions. One thing I often hear from people who are already retired is, I am too old to do a conversion; it won't really make sense.

First, let's get into the thinking behind why age might be linked to whether or not a Roth conversion makes sense.

Bruno: I do think a lot of retirees struggle with that in terms of … well, I am retired. I'm not contributing anymore. Can I convert? Should I convert? They're thinking of their time horizon and whether it makes sense. So, there are a lot of variables that factor into that conversation. But many times a conversion could be very viable.

Benz: Let's talk about some of the categories where a Roth conversion probably won't make sense. You noted that if you are using your traditional IRAs for spending money, then that will tend not to be a great fit in terms of doing a Roth conversion.

Bruno: Yes. The thought there is, if you're spending those IRA dollars anyway for your expenses or maybe there are RMDs and you're spending those, then a conversion may not make sense because you're accelerating that tax liability.

Benz: So, you're paying more than you actually would need to versus if you were just taking income from that IRA on a year-to-year basis?

Bruno: You're accelerating that tax liability, which potentially could put you into a higher tax bracket. Those are some of the nuances that you'd want to think about.

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Benz: You mentioned for people who have a charitable intent, in some cases it's better to hang on to that traditional IRA than doing the conversion.

Bruno: That's another area where you want to think about it. If you have charitable bequests, if you … have a charity as the beneficiary [of a traditional IRA], those assets can pass to the charity without any tax consequences. So, basically, you're not accelerating any type of tax liability. You'd get the full value of the traditional IRA. In that situation a Roth may not make sense.

Benz: The charity would, in fact, actually inherit more from you if you left it in the traditional IRA wrapper?

Bruno: Well, they get the balance of both the traditional or the Roth, but there's no tax liability on the account owner by [donating the traditional IRA assets versus converting to a Roth and then donating].

Benz: Let's talk about the profiles for whom a conversion might, in fact, make sense in retirement. People who do not need the income from their IRAs, you say, might be good candidates for doing the conversion?

Bruno: Right. One area where it might be attractive is if you're a new retiree, for instance, and you might be in that period where, after retirement, your income tax bracket might be lower than it was during your peak earning years. And it might be lower than it might be later when you're taking RMDs, because that is taxable income from the IRAs. So, that might be an area of opportunity for a Roth conversion.

There are a couple of benefits there. If you don't need those IRA assets and you want to pass them to your children or grandchildren, a conversion might be attractive for several reasons: One is, you don't have to take lifetime RMDs from the Roth IRA. So, those assets continue to grow tax-free. That's one clear benefit.

The other thing is any type of withdrawals from the IRA, for instance, wouldn't be factored into the calculation of whether Social Security benefits are taxable. So, there may be some benefits to that as well. So, it does offer some flexibility.

The other thing, too, is it provides tax diversification. If you have taxable, tax-free, and tax-deferred assets, as a retiree, if you do need to spend from the different buckets, you can spend strategically in retirement as well.

Benz: What's your advice to people trying to get their arms around this issue? It sounds like they should try to plot out, to the best of their abilities, what their income and, in turn, their tax brackets might look like from year-to-year as retirement progresses. Do you have any other tips that you can give people for making sense of this very difficult question?

Bruno: A lot of it is based upon tax expectations--current versus future--but many retirees don't know. But you may have a sense of, on a year-by-year basis, if you have an atypical tax situation. Maybe you might have high medical deductions that might put you in a lower tax picture one year--then, maybe that additional [taxable] income from a conversion might not be so bad, and there are some benefits there.

Certainly, you want to consult a financial planner or a tax advisor, but those are some key areas where it might be appropriate.

Benz: Converters have a couple of tools that make it a little more flexible in that they can do the partial conversions as well as the recharacterizations.

Let's start just by talking about partial conversions--that means that you just convert a portion of your traditional IRA assets to Roth. You don't have to do the whole kitty at once.

Bruno: Right. It's important to reinforce it's not all or nothing. Oftentimes, partial conversions are a great way to get the tax diversification benefit and stagger out the tax consequences to manage your income tax bracket on a year-by-year basis. Partial conversions are oftentimes a very viable strategy.

Benz: Then the recharacterizations--if it turns out, oops, I shouldn't have done that, you can actually go back to the traditional IRA and not have any tax consequence?

Bruno: Correct. That's one benefit on the IRA side, in that if you decide that you want to undo that flexibility--there are holding-period [requirements] there to be able to do that--but the flexibility is there as well.

Benz: What are some examples of situations where that might come up--where someone will make a conversion and then realize that it probably wasn't the best thing to do?

Bruno: We often see recharacterizations for a couple of reasons. One is the value of the account today. Let's say, the year after you convert, maybe six months after, the value of the account might be lower than it was when you converted. So, you might be able to, or want to, reverse that conversion.

Benz: Because you paid more tax than you really had to.

Bruno: Yes, and then you can wait a certain period and then reconvert as well. Sometimes it's a tax liability play. Sometimes it's: Whoops, I converted too much and it bumped me into a higher tax bracket, so I might want to unwind some of that and maybe do it in a subsequent year. Or the tax liability is higher, and I don't have the cash or I don't want to part with the cash to pay that tax liability. Those tend to be the common themes.

Benz: A lot of moving parts here, obviously, Maria. Thank you so much for being here to share your insights.

Bruno: Thank you.