Deciding if a Roth IRA Conversion is For You
Roth IRAs can be a powerful tax tool, but they are often misunderstood and misused. Investment income in Roth IRAs compound tax-free and most distributions are tax-free as well. Another benefit is that there are no required minimum distributions (RMDs) throughout the original owner’s life. Long-term Roth distributions are tax-free to the beneficiaries who inherit the IRA as long as they fully distribute the Roth within 10 years of inheriting.
As the annual contribution limits are rather small, most Roth IRA contributions are made by converting a traditional IRA to a Roth IRA. The downside to conversion is that you will have to pay tax on the gross amount converted. Considering this can require a substantial cash outlay and that all the Roth IRA benefits are backloaded, deciding to make a conversion can be a difficult call.
Most people are not sure it will pay off in the long term and do not like the idea of paying taxes now instead of in the future. Consequently, too often people try to make a conversion decision through intuition instead of objectively considering the important factors.
It is best to use a spreadsheet to do an analysis or work with a tax advisor because you will need to consider many factors, including assumptions about tax rates, investment returns, how long you will own the accounts, how much you will convert, etc.
Generally, a conversion becomes more advantageous if tax rates increase and this impact is compounded by higher investment returns. Finally, remember that you can leave the Roth to your heirs who can take distributions tax-free.
Roth IRA conversions are not the right option for everyone, but where it is appropriate the benefits can be substantial.
For more information, please contact your LSZ advisor.