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Financial Planning > Tax Planning

4 Key Advantages of Roth Conversions for Retired Investors

By Jeff Berman

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There are four key advantages of Roth conversions for investors in retirement, according to Joel Dickson, global head of advice methodology at Vanguard.

“There are a lot of things that can change in retirement,” he said during the Financial Planning Association’s online conference Wednesday.

“First of all, the federal tax brackets are wildly different for married and single individuals and marital status can change in retirement,” he said. “It can change for a number of reasons,” including divorce and the death of a spouse, he pointed out, before laying out the main advantages of Roth IRAs:

  1. Federal tax brackets are more favorable for married couples filing jointly than for single individuals, and Roth IRAs let you lock in current tax rates.
  2. Conversions reduce future required minimum distributions on traditional IRAs.
  3. Withdrawals do not factor into the 3.8% Medicare surcharge or Social Security benefit taxation.
  4. There are no lifetime RMDs.

Tax-Efficient Investing

“It’s important just to recognize that, a lot of times, clients don’t necessarily understand or know a lot of nuances from a financial planning standpoint, and we really believe that financial planning elements of the advisory relationship can add as much or even more kind of value in and of itself than even the investment portfolio,” Dickson said at the start of the presentation.

And one way to do that is with tax-efficient investing, he noted. There are generally two ways to add value from a tax efficiency standpoint: “One is deferring taxes as long as possible” and the second one is “there may be opportunities to pay taxes now to avoid higher tax liabilities in the future,” he said, pointing out the latter would be the focus of his presentation.

During the session, he discussed the concept of a break-even tax rate (BETR) calculation that he said provides a more accurate view of what future tax rate expectations would guide an advisor’s and an investor’s choices and help inform a Roth conversion discussion.

Dickson also explained the potential benefits, such as improving retirement income and estate planning outcomes, of advisors and investors expanding their use of Roth contributions and conversion strategies.

“I like to think about traditional and Roth [IRA] accounts as being the opposite sides of the same coin. You’re getting tax-advantaged growth and you’re getting some form of tax-advantaged investment either on the way in or on the way out,” he said. “On the Roth, you get the tax benefit on the way out, which is that the withdrawals are tax-free.”

Another key difference with the Roth IRA is that there are no lifetime RMDs, while with the traditional IRA you must start taking RMDs when you reach age 72, he pointed out.

Although about 4/5 of assets in IRAs are in traditional IRAs now, “more people actually contributed to Roth IRAs this year,” he noted.

It is not, however, always beneficial to convert from a traditional IRA to a Roth IRA, he stressed.

4 Main Benefits of Roth IRAs

There are four main benefits of Roth accounts overall, he said:

  1. The ability to lock in current tax rates.
  2. The ability to save more on an after-tax equivalent basis.
  3. Tax-free withdrawals in retirement.
  4. Estate planning tax efficiencies.

The “rule of thumb” has long been that “if your future tax rate is going to be higher than your current tax rate, you might want to think about the Roth; if it’s going to be lower, you might want to think more about the traditional IRA,” he pointed out.

However, one key factor to take into account is that “if the tax rate doesn’t change, it doesn’t matter whether” you have a traditional or Roth IRA, he said.

4 Tax Implications to Consider When Converting

The key tax implications include two main conversion opportunities:

  1. An atypical, lower tax year may be a good time to convert.
  2. The charitable contributions cap is based on adjusted gross income, which conversions increase.

And they include two main conversion limitations:

  1. It could bump an investor into a higher marginal income tax rate. (Although a mitigation of that could be partial conversions rather than full conversions.)
  2. Additional income from conversion is not subject to the 3.8% Medicare surtax, but it could trigger the tax on other passive income.

Estate Planning and ‘Backdoor’ Roth IRAs

Dickson also pointed to three estate planning considerations for beneficiaries: Traditional IRA and Roth accounts require RMDs, and the estate tax is tax-inclusive while conversion can be tax-exclusive with both, while only with a Roth account can the investor receive an asset without an embedded tax liability.

He went on to explain the criteria for a “backdoor” Roth IRA, which provides a way for high-income investors to sidestep the Roth’s typical income limits. This strategy works best if the investor doesn’t have other traditional IRA assets, he said, noting that, otherwise, part of the conversion would be subject to income tax.

Under the backdoor Roth, you first make a nondeductible contribution to a traditional IRA, then convert your traditional IRA into a Roth IRA and, finally, contribute directly to the Roth IRA, he explained.

— Check out The Mega Backdoor Roth IRA and Other Ways to Maximize a 401(k) on ThinkAdvisor.

Jeff Berman

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