An IRA Conversion Sweet Spot

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many investors with traditional IRA balances wrestle with whether--and when--to convert those traditional IRA balances to Roth. I recently sat down with Vanguard's Maria Bruno to discuss timing those conversions to reduce the tax impact.

Maria, thank you so much for being here.

Maria Bruno: Thank you, Christine.

Benz: You work on retirement planning at Vanguard, and one area of interest for you is Roth IRA conversions--converting traditional IRA balances to Roth. Let's talk about, first of all, why someone would even want to do this, because it really is delay of gratification. You're taking a tax hit to do these conversions in exchange for tax-free withdrawals down the line.

Bruno: Absolutely. You are taking a tax liability today for some type of economic benefit down the road. The question is why do this--you're doing this for what? The Roth can offer a couple of benefits. One is certainly the tax-free growth; the other is no lifetime RMDs. So, for individuals who don't need their RMDs to live off of, the flexibility of not having to take those distributions and incur income taxation can be very attractive for retirees. There are also estate-planning benefit in terms of passing assets to heirs that aren't subject to income taxation upon their receipt and distribution.

The other reason is the overall benefit of tax diversification. Holding different account types--be they taxable, tax-deferred, or Roth--really gives an individual lot of flexibility to be as tax-efficient both in their planning and their spending, but also in terms of wealth transfer. The other thing I would add in terms of Roth is the ability to access the contributions or the conversion dollars. So, it does offer some flexibility down the road as well, if needed.

<TRANSCRIPT>

Benz: Let's talk about the profiles for whom a conversion would be particularly well suited. What category should I be in as an investor to even consider this?

Bruno: Generally, I really would make the recommendation that anyone should consider it. Whether they should do it or not is a really case-by-case basis, but there are a few general guidelines to think about. First, if you are a young investor, the benefit of the tax-free growth can be very appealing. Certainly with a traditional tax-deferred 401(k) or IRA, for instance, there is a deduction on the contributions, generally speaking. But because you are in your low-earning years, the benefit of a Roth and the tax-free growth far outweigh the immediate tax benefit on the contributions.

So, certainly that is a cohort for whom Roths make sense. And we are seeing this as well in terms of contribution dollars going overwhelmingly to Roth for the young cohort. And the other is really, as you think about it even in your later years, the ability to benefit from tax diversification and having the different account types and providing the flexibility down the road. And, again, for individuals who don't need their RMDs, holding Roths can be very attractive because you don't have to take the distributions and be taxed on those dollars later.

Benz: One life stage that you say is kind of a sweet spot for considering converting these traditional IRA balances to Roth is the years between age 60 and 70--or maybe postretirement up until age 70. Let's talk about why that band can be a particularly fortuitous time.

Bruno: Let's actually unwind that a little bit and think about people maybe in their 50s, too, who are contributing. Those individuals can take advantage of catchup contributions as well. They can actually direct their contributions to a Roth vehicle, certainly if it's available within their 401(k) but also potentially in Roth IRAs. There, you have the ability to direct contributions. Once you are retired, that's really the only option that you have if you don't have Roths--and many retirees today don't have Roths. They are really facing retirement with large tax-deferred traditional balances.

During that window might be an attractive time, particularly if you are not taking Social Security at full retirement age. So, for individuals who are delaying Social Security to age 70, for instance, that coupled with RMDs could potentially cause someone's tax situation to go a little bit higher during that period. So, looking at that window between 60 and 70 perhaps could be very attractive in terms of trying to maximize potentially relatively lower tax brackets. And we are seeing this actually with our Vanguard IRA investors. While overall conversions are still relatively low, we are seeing conversions increase up to--and actually peak at--age 70. So, that leads us to think that people are actually converting as a way to manage their future RMDs.

Benz: One other thing in the mix is the market. Obviously, there are some complicated factors in the decision-making process here, but the market has performed really well. Balances are on the high side when people look at their traditional IRAs today. Arguably, that makes conversions a little less attractive because you will pay ordinary income tax on that whole IRA kitty when you do a conversion. Let's talk about how market movements figure in here.

Bruno: Certainly, if you are looking to do a conversion, the more you can minimize the income tax liability on that conversion, the better. It's really difficult to time, though. But you are right: The markets have been quite generous over the past couple of years, and you need to be very thoughtful in terms of conversions. It's important to mention that you don't have to convert your entire IRA balance; in fact, in these situations, partial conversions could be quite financially advantageous rather than doing everything all at once, because that could easily put you into a higher tax bracket. So, to be thoughtful about the conversion, I don't think the market should drive whether or not you convert. I think the conversion decision in terms of your overall financial-planning picture is paramount. It's then about how you do the conversion. What types of balances do you convert? So, it's actually more in the implementation of it.

Benz: Lastly, I want to discuss the escape hatch. If you do a conversion that later turns out to have been ill-advised for one reason or another, that recharacterization option may be a way to undo a conversion that you later regretted.

Bruno: In this situation, the IRS actually gives us quite a nice perk, which we don't often get from the IRS. There is the ability to recharacterize a conversion--and it can be a partial recharacterization or full recharacterization. Essentially, what that does is it gives one the ability to actually reverse the conversion; the monies as well as any potential earnings would then go back into the traditional IRA. And there is a conversion window for that. If you do a conversion this year, you actually have until October 2016 to reverse all or part of that conversion. So, it does give some flexibility in case you change your mind or maybe your income tax picture has changed and the additional conversion income could bump you into a higher income tax bracket where you might want to unwind some of that. So, the flexibility is there to unwind part or all of it, if need be.

Benz: Maria, thank you so much for being here to share your insights.

Bruno: Thank you, Christine.