Key Takeaways
No one know what the new tax landscape will bring, but rates will likely be higher, not lower, for affluent successful people.
When deciding if it’s time to convert your tax-deferred retirement savings to a Roth, don’t forget to consider your charitable and inheritance goals.
The decision can be complex, don’t be a do-it-yourselfer here.
Potential tax law changes have led several of our clients to ask if a Roth conversion is right for them. For those still working, more and more employers are offering 401(k) plans with “in plan” conversion features. If you are already retired, you may be concerned about the potential for higher tax rates and are also asking if it makes sense to convert to a Roth. The decision about whether or not to convert comes down to when you want to pay the tax on the retirement income you’ve worked so hard to save. With a traditional retirement account such as a 401(k), you pay tax when you start taking your money out of the account. With a Roth, you pay the tax upfront when you start making contributions.
Clients often ask me if there’s a certain stage of life when it’s better to have a Roth instead of a traditional retirement account. There’s no one-size-fits-all answer to that question. It all depends on your goals and your overall financial situation. Generally speaking, it’s better to have a Roth early in your career when your income is lower. Roths are also a great way for parents and grandparents to get kids accustomed to saving money from summer jobs or other sources of income. Just a few thousand dollars in a child’s or teen’s account can become quite substantial after several decades of tax-free growth.
Structure of Your Assets
The decision to convert to a Roth depends on many factors. One factor is the structure of your savings. If you’re in your 50s or 60s and at the peak of your career earnings, if the bulk of your retirement saving is in a traditional 401(k), then your income tax rate may not change much when you retire. That’s because all of your retirement income will come from that traditional 401(k)--income that becomes taxable (just like a paycheck) --when you start withdrawing from the account. It may not be a good idea to start converting at this time because the conversion will simply count as income on top of your salary.
However, if the bulk of your savings is in a joint account or a revocable living trust (which is mostly taxed at the lower capital gains rate), your tax rate will likely be a lot lower in the future when you retire. NOTE: There will be more opportunities later in life to convert from a traditional 401(k) to a Roth at a lower tax rate. Deciding whether to do a Roth conversion now is based on an analysis of your current tax rate vs. what you think it will be when you need to withdraw the money. Determining your current tax rate is easy. The harder part is estimating what your tax rate will be in the future, and if there will be any opportunities to convert to a Roth at a lower tax rate.
This is where professional advice can be very helpful. A season advisor will be in better position to ask the right questions, analyze your financial situation, and project future tax rates based on current law.
The decision to convert to a Roth also depends on your goals. One of the first things we look at are your charitable intentions. We also want to know how much you wish to leave to family members when you pass away.
On the philanthropic side, we can help you with qualified charitable distributions that will lower your income in future years and thus, put you in better position to convert to a Roth. But if inheritance is a bigger goal for you, that’s a reason to convert to a Roth sooner rather than later. Doing so will enable your money to grow tax-free for the rest of your life and for up to 10 additional years of your beneficiaries’ lives.
If your philanthropic and inheritance goals are equally important, a charitable remainder trust (CRT) may be a good fit for you. With a CRT, family members get income from the trust throughout their lives and then when they pass, the charity receives the nice lump sum that’s remaining. Roth conversions are not as desirable if money in your retirement accounts is going to be left to charity.
The Roth conversion decision also does depend upon your perspective on taxes. Some clients are all about “defer, defer, defer” when they first come to see us. They try to minimize their tax bite every single year and there is nothing wrong with that. But there’s another school of thought that says you should instead focus on paying as little tax as possible when you withdraw money from your retirement accounts. In some cases, this means getting your big tax hit out of the way now—while tax rates are still historically low--so you can move on to a worry-free retirement down the road. I’m not a gambler, but if I had to place a wager, I’d put my money on tax rates being higher, not lower, in the future.
Conclusion No one really knows what the new tax landscape will bring, but one thing you can count on, it pays to be prepared. As Benjamin Franklin liked to say: “Failing to plan is planning to fail.” There’s no reason for that to happen to you. If you or someone close to you has concerns about their retirement readiness or tax situation, please don’t hesitate to reach out. We are happy to help.
RYAN M. VOGEL, CFP® is the CHIEF PLANNING OFFICER,
PARTNER at Novi Wealth