- The key benefits of converting a traditional IRA or 401(k) to Roth are tax-free growth and there's also flexibility in terms of being able to access, whether it's contributions or converted dollars, after the five-year holding period.
- When you take the distribution, you have the option of withholding taxes and converting the net amount or converting the whole amount, and then the key there is you want to make sure you have money set aside, most likely in a cash account when it's tax time and you have to pay that tax liability.
- The optimal years for Roth conversions can be years leading up to RMDs, particularly before you start claiming Social Security, you might be in a relatively lower tax bracket.
Christine Benz: Hi, I'm Christine Benz from Morningstar. With many investors' portfolio balances down so far in 2022, we've been hearing a lot of chatter about whether the time is right for Roth conversions. Joining me to discuss some key considerations in that area is Maria Bruno. She is head of U.S. Wealth Planning Research for Vanguard.
Maria, thank you so much for being here.
Maria Bruno: Hi, Christine. Thanks for having me.
What Are The Benefits of Converting to Roth?
Bruno: There's a few key benefits, the obvious one being tax-free growth. So, when you convert assets, you're taking an asset with an embedded tax liability, paying the income tax on that, and then converting it to tax-free growth. The other thing is no lifetime RMDs, and that's a big one. For IRAs, account owners are not required to take distributions during their lifetime; beneficiaries will, but they are tax-free. So, the tax-free growth coupled with no RMDs is quite powerful. And then, there's also flexibility in terms of being able to access, whether it's contributions or converted dollars, after the five-year holding period. So, there's a lot of flexibility that goes with Roth accounts that we don't see with traditional tax-deferred-type vehicles. And then there's even more flexibility once you reach age 59 1/2. So, there's lots of tax benefits to incorporating Roth into your portfolio, and that's basis of tax diversification, holding different account types, whether it's taxable, tax-deferred, or Roth.
How Can Taxes Be Reduced During a Conversion?
Benz: Okay. So, you referenced that this is not a free lunch, that you do owe taxes, typically when you do a conversion. So, let's talk about how those taxes are calculated. And I guess, another key question that is probably on investors' minds is whether there's any workaround, whether there's any way to reduce them. Can you talk about that?
Bruno: Sure. So, a Roth conversion is a taxable event. So, for many, when you're doing the conversion, it's a distribution from a traditional deferred account, whether it's a 401(k) or an IRA. So, the amount that you convert, typically the full balance is a pre-tax balance, meaning the entire amount is subject to income taxes. So, it becomes a line item on your tax return when you file your taxes. So, the mechanics, when you take the distribution, you have the option of withholding taxes and converting the net amount or converting the whole amount, and then the key there is you want to make sure you have money set aside, most likely in a cash account, when it's tax time and you have to pay that tax liability. And in fact, that is the best way to optimize the Roth conversion. If you can pay the income taxes with non-retirement assets, that allows the full amount of the IRA or the 401(k) to move over into the Roth account and then grow tax-free.
Benz: Okay. So, in that case…
Bruno: So, those are the mechanics of it.
Benz: Sure. In that case, you wouldn't have withholding taken out as you do that distribution, as you do that conversion.
When Is a Good Time to Consider Conversions?
Benz: So, let's talk about what you've called kind of a sweet spot or a really good life stage to consider these conversions. You say that in the post-retirement, pre-required minimum distribution years, those can be really opportune years to consider doing conversions. Can you talk us through what the benefits are?
Bruno: Yes. We call that the Roth conversion zone. It's a really good time to think about how do I—basically what you're doing is you're planning for RMDs and creating that tax diversification where you may not otherwise have had that. Many people have deferred their contributions into tax-deferred balances, and they have these large tax-deferred balances which will be subject to RMDs at age 72, and then large tax liabilities to go along with that. So, when you think about planning for RMDs, you want to do that well in advance.
So, those optimal years can be—and when I say can, it's not for everyone—but it can be those years leading up to RMDs, particularly before you start claiming Social Security, you might be in a relatively lower tax bracket. So, those may be instances where it may make sense to do a series of partial IRA conversions. And you're creating that tax diversification; you're also lowering the traditional deferred balances, which then also lower future RMDs. So, basically, you're accelerating taxes today. The plan is to pay them at a relatively lower rate and then enjoy the tax-free growth as well as potentially lower RMDs later. So, that's the theory behind it. And we are seeing more retirees—the numbers are quite low. It's still tough to accelerate tax liabilities. But I think more individuals, probably with the help of financial planners, are becoming more educated around RMDs and the "tax torpedo" that they sometimes call, and start planning for RMDs well in advance of age 72.
The other thing to keep in mind with these RMDs is that the pre-tax balances, much like the conversions, are subject to income taxation. So, there are other triggers, whether it's the taxation of Social Security or Medicare Part B surcharges. There are different thresholds, and you might spike into different marginal brackets as a result of that. So, it is a way to smooth this overall tax liability through retirement.
Benz: Okay. So, it sounds like get some tax help in this area.
Bruno: Right. Yeah.
Are You Too Old To Convert?
Benz: One question that comes up a lot in this area, Maria, is whether someone is too old to convert. I sometimes hear from retirees who have been retired for 10 years or more, and they say, well, what if I'm not around to enjoy that tax-free growth. So, the question is, Can you be too old to convert?
Bruno: Not necessarily. Depends what the goal of the money is. If you have someone who is a higher-net-worth individual and the goal is to pass those assets to their children or grandchildren, you really want to think about what your tax bracket is today relative to who is going to be enjoying the money later. If you're passing it to children or grandchildren who are in a higher tax bracket, for instance, then it may make sense to convert those dollars today. Again, it's the same notion of what you're doing for planning for RMDs. It may make sense to make the conversion today, pay the taxes at a presumably lower rate and then pass a tax-free asset— income-tax-free asset—to the beneficiary. So, that's kind of the way you want to think about it. I would actually reframe it and say you're never too old to consider a Roth conversion. Whether or not you do it, it depends upon what your goal for the account is. But everyone should kind of think through what is the goal of those monies and when does it make sense to pay the taxes?
The one thing I do want to stress, though, is you want to be careful in terms of how much you convert. It's not reversible. So, generally speaking, you cannot recharacterize these monies once you convert. So, you do want to be careful how much you convert, so as you don't bump yourself into a higher marginal bracket inadvertently.
What Are the Market Effects on Conversions?
Benz: Okay. Good point on that. So, we've been hearing a lot about conversions in 2022 in part because many individuals' balances are down. We've seen the stock and bond markets go down. Can you walk us through how market environment might fit into this? We've kind of talked about how life stage and eventual goals might be a factor, but how about market effects?
Bruno: Right. So, that's the mechanics of it. And I think you've talked about this too in terms of the silver lining of market volatility. So, when we have this, are there opportunities to incorporate some tax techniques? And Roth conversions can be one of them. So, if the account balances are suppressed, then it may make sense to take a look and see whether a conversion is appropriate. A couple of things to keep in mind is, while you can be surgical around which account you convert or which asset you convert, and you want to be, for purposes of maybe rebalancing—so, you want to be mindful in terms of what asset you convert—but then, when you go to actually calculate the tax liability, the IRS doesn't let you cherry-pick which asset you're going to use the basis on. You need to aggregate all of your IRA balances and use that as a basis for calculating what your taxable amount is. So, there's the mechanics of it in terms of which asset and which investment you convert. But then, when you go to calculate the taxes, you have to aggregate all your deferred balances, the IRS doesn't let you cherry-pick the most-suppressed asset and then pay taxes on that. You have to aggregate everything.
Benz: Okay. That's super helpful. This is a perennially hot topic among our investors', IRA conversions. Thank you so much for being here, Maria, to walk us through some of the key considerations.
Bruno: Happy to. Thank you, Christine.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.
Watch "Retiring in a Down Market? Consider These Strategies " by Christine Benz.