Roth Conversion: Decision Scenarios

Instructor, Caroline Bender

You have read or heard through your preferred news outlets that investors may now convert their traditional IRA savings into a Roth IRA and reap the benefits of tax-free retirement withdrawals in their older age. What you have always wanted -- a paycheck in the full amount of what you earn (however you set your payroll in your golden years). If internet research has brought you to this post, then you are likely reading everywhere what you are about to read here: there is no universal answer to "Should I or Shouldn't I?"

We applaud you for trying to learn more; we are flattered that you chose us out of the many search results you must have been offered. What we want to stress to you is that you should not make such a significant financial decision without consulting an expert -- one who does not reside inside Google. We at the Finishing School are not financial advisors, and the School is not authorized to dispense financial advice. What we do is try to bring abstract ideas like money and work and raises and balance and performance reviews and "having it all down" to real life narrative so you can figure out who to use the information at hand.

Here are the terms you need to know
Roth: specialized individual retirement account that does not require automatic withdrawal at a given age, is transferrable, and taxed on contribution rather than withdrawl, allowing a smaller tax on a larger account. (named for the late William Roth, [R] Delaware)
Traditional: individual retirement account that allows tax-deductible contributions, and tax on the withdrawal as mandatory income at a determined age.
Taxes: When and how much. What you are really chosing here is whether to pay tax on funds you convert now, or funds you withdraw later. As they say around your workplace (and mine) "it depends."

Yes, I always say, I am sure it does. Depends on what?
Here are the factors to consider with your family and financial advisors before taking the plunge.

What is the money for?
For most of it, it is our retirement income, but if you also have a pension or other annuity, your IRA may be your investment fund, a savings fund to be given as inheritance, or your Foxwoods account.

Who is the money for?
Similarly, is this an individual fund, an income for a retired couple, or an older couple with other dependents, such as grandchildren, siblings.  This question also answers How long does it need to last, which is also related to How long might you be being taxes on it?

Is is easier/more palatable for you to pay a large up-front tax or small back-end taxes over a period of time, depending on how long that period might be?

How old are you? In other words, how much time does your Roth have to grow, and how big might it be when you begin withdrawing?

What is your income bracket and how much money are we talking about?

Take, for example, an individual with 100K in a traditional account (IRA or 401k) today.
The 40 year-old may not have the cash on-hand to convert today, or want to liquidate $35K for the promise of a tax-free future.
The 60 year-old may have the cash and another 20 years to build interest before they want to/need to begin withdrawing.
The 75 year-old may actually save cash by paying tax on small withdrawals for 10 more years

A family may prefer the tax deduction today when expenses are plentiful over tax-free income in a future when there are fewer responsibilities and unexpected costs.
A single person may prefer building income in his/her name, when it is easier to control personal spending.

Will taxes go up....?  Or down...?  by the time you are withdrawing?
What will your income do?
A 35% tax bracket or higher can make that contribution tax feel like a sock in the stomach, especially if you will be in a lower bracket when you retire.  But what will "lower" mean in such a distant future? 

The entrepreneur with a big idea may prefer to pay a contribution tax at his Garage Inventor tax bracket of 25%.  before his hopes of future wealth may come true.
The union man with a known future income plan may have a pension to rely on and may rarely contribute to his IRA.
The 2nd wife may be building an inheritance for her grown children.  Roths are transferrable.

If we are your first stop on your research journey, let us recommend a few other resources to help in your scenarios.  Do not expect any of them to tell you what to choose, but do work your own situation against the possibilities of your income changing, the tax rates changing, the tax laws changing, the amount in your account changing (anyone remember last year?)  and your needs for that savings changing.  Then make your best all-around decision.  And don't be too scared: you can reverse your decision  if you get cold feet.

Related resources:
Suze Orman: No Match?  no Sweat?
Ameriprise: 2 Scenarios
Daily Worth: IRA Math