Financial planning experts broadly agree that Roth conversions are a powerful tool that can help clients amass significantly more wealth for retirement, but they are also a nuanced strategy that must be used carefully to avoid unintended consequences.
A new analysis shared with ThinkAdvisor by the Colcom Group, a consulting firm, explores the intricate conversion dynamics. To make an informed decision, the report suggests, clients must understand the key differences between traditional and Roth individual retirement accounts — and how those differences align with their long-term financial goals.
Adding to the pressure, changes made under the 2017 tax overhaul known as the Tax Cuts and Jobs Act mean that Roth conversions can no longer be undone — making it all the more critical to weigh the pros and cons carefully.
As advisors will already know, the primary advantage of a traditional IRA is that contributions clients make are tax-deductible (up to a specified limit). Traditional IRA distributions that are attributable to deductible contributions or growth in the account, however, are taxable at ordinary income rates.
The primary advantage of a Roth IRA, on the other hand, is that qualified distributions from the account are tax-free. Qualified distributions are those made from a Roth IRA that has existed for at least five years, as long as the account holder is 59 1/2 or older. Nonqualified Roth IRA distributions are taxed at ordinary income rates, subject to special “ordering rules.”
These rules stipulate that, when a client takes a Roth distribution outside of the tax-free parameters, the contributions are treated as coming out first. Because the client has already paid tax on those amounts, contributions are exempt from tax when withdrawn. Next come conversions and rollover amounts, and finally, earnings.
After spelling out this framework, the Colcom Group analysis goes on to share a number of key questions clients and their advisors should ask before converting a traditional IRA to a Roth-style account. See the slideshow for a review of these questions and some of the report’s key conclusions.
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