Roth IRA Conversions - What to Consider

We’ve been getting a number of questions about Roth IRA conversions lately, and although we have covered this issue in the past, we thought it made sense to do so again since it’s been quite a few years. The question most often asked is: “Should I convert some or all of my Traditional IRA dollars to a Roth IRA?”.

While there are plenty of financial professionals who will suggest that one should ‘always’ convert to a Roth IRA to take advantage of tax-free withdrawals at retirement, and still others who suggest the opposite, i.e. to avoid paying the taxes until retirement, the truth is that, as with most financial decisions, there is no one-size-fits-all answer to the conversion quandary. However, the basics behind this decision are really fairly straightforward, and come down to one simple question, “Will I be in a higher or lower tax bracket when I eventually withdraw funds from my retirement accounts?”.

If you believe you will be in a higher tax bracket when you withdraw funds from your retirement accounts, then converting to a Roth IRA (and paying the resulting taxes at lower current rates) makes the most sense.

If you believe you will be in a lower tax bracket when you withdraw funds from your retirement accounts, then keeping the money in a Traditional IRA (and paying the resulting taxes at lower future rates) is the best strategy.

If you end up in the same tax bracket as you are now when you withdraw funds from your retirement accounts, then it makes no difference at all.

For all the debate about where future tax rates might be heading, the reality is that no one knows for sure. As a result, if, like most people, you do not know whether you will be in a higher or lower tax bracket in the future, your best bet, as usual, is to diversify.  In other words, convert some to a Roth IRA and leave some in the Traditional IRA. This is quite simply tax diversification, which gives one the flexibility to take advantage of whatever tax structure is in effect in the future, and, as in most financial endeavors, diversification is decidedly a good thing.

One final consideration is that to maximize the effectiveness of the Roth IRA conversion, funds to pay the current tax liability caused by the conversion really need to come from non-IRA sources. If the funds used to pay the taxes come from inside the IRA account, the loss of the compounding effect that tax deferral has on those dollars over time, will likely render the conversion ineffective.

The question of whether to convert to a Roth IRA certainly comes down to individual circumstances, but to convert or not to convert…the answer is most often ‘yes and no’.