Thoughts on Roths

By Zeke Anders on September 9, 2021

Written By: Zeke Anders

Roth IRAs are a terrific tool for funding retirement, as the investments in the account can grow tax-free, and can be withdrawn tax-free after age 59 and ½ or left to heirs. However, due to the income and contribution limits, it can be difficult to amass a large amount of assets through direct contributions to a Roth IRA. Many people have the bulk of their assets in an employer-sponsored retirement plan like a 401(k) or Thrift-Savings Plan. As a result, Roth conversions are a common method for getting more assets into this tax-free bucket.

Roth conversions come with a trade-off though. In a Roth conversion, you (generally) pay taxes today on funds that were tax-deferred in a 401(k) or IRA. Given this, when does a conversion make sense, and how much should you convert? The two main aspects to consider are tax rates and time. The common wisdom is that if you expect your tax rates to increase in the future, you should do a Roth Conversion to lock in today’s rates. That may be true, but future tax rates are difficult to predict. Many tax rates were decreased in 2017, and the current administration has so far focused tax increases on households with $400,000 or more in annual income. That said, the current tax rates will automatically increase at the end of 2025 if they are not extended by Congress. An opportune time to execute a Roth conversion is the gap between retirement and age 72, when Required Minimum Distributions begin. Generally, income drops during this period, which might allow you to take advantage of a lower tax bracket.

Even if your tax bracket stays the same throughout retirement, a Roth conversion can still be beneficial by reducing Required Minimum Distributions. Once you turn age 72, you will be required to distribute a certain amount each year from tax-deferred accounts like 401(k)s and Traditional IRAs. The distribution amounts change each year, starting small and then growing over time. At some point, these distributions may be larger than what you actually need to withdraw to cover annual expenses. If that occurs, you’ll be paying taxes on income you didn’t need in the first place. Instead, you could estimate these excess distributions and convert them to a Roth IRA, which does not have Required Minimum Distributions. Consider, though, that the breakeven point of this strategy can be 25 years or greater.

One option, for those that are still working and have access to a 401(k) plan, is a “mega backdoor Roth Conversion”. Per the Wall Street Journal, many 401(k) plans allow after-tax contributions once you have exceeded the $19,500 limit on pre-tax or Roth 401(k) contributions. Total contributions to a 401(k) can be as much as $58,000 for those under age 50, or $64,500 for anyone 50 or older. If your employer allows in-service distributions, which many do, but only after age 59 ½, you can roll these after-tax contributions into a Roth IRA right away.

Making the decision to convert pre-tax funds to a Roth is highly dependent on your situation and goals. We should focus first on having adequate savings, and a diversified portfolio with a prudent asset allocation before optimizing for income taxes. But if you have been thinking about a Roth conversion, we hope this provides some food for thought.

Zeke Anders-Planning Specialist | zanders@twickenhamadvisors.com

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Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.