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ROTH IRA Conversions – Don’t Rely on the “Rule of Thumb”

ROTH IRA Conversions – Don’t Rely on the “Rule of Thumb”

May 07, 2024

If you have ever considered a ROTH conversion you’ve probably heard, and possibly followed, this rule of thumb: If your tax-bracket will be lower during retirement vs now, then a ROTH (and ROTH conversion) is not appropriate, and if your tax-bracket will be higher during retirement, then a ROTH could be attractive. While "rules of thumb" often come in handy, in this case it is insufficient. Why? One, because it fails to consider the taxation as income of the capital gains in traditional IRAs, and two, it ignores the legacy tax-free growth of inherited ROTH IRAs.

With a traditional IRA, contributions are made before-tax and are taxed at the time of withdrawal. The account owner is subject to annual required minimum distributions (RMDs) beginning at age 73, the amount which includes tax-deferred contributions as well as accrued gains, all of which are taxed at the account owner's marginal income tax rate. Furthermore, if the IRA withdrawals are re-invested, all future investment income and gains are also subject to tax. So, in effect, the gains from IRAs are subject to tax in two ways: at the income tax level at the time of withdrawal then ongoing taxes on future gains of the reinvested withdrawals. This is true at the account owner level AND at the beneficiary level starting in the first year after inheritance over ten years.

However, ROTH IRAs are funded with after-tax dollars, and they incur no future taxes EVER, in your lifetime – there are no RMDs on a ROTH and all investment gain is tax-free. Furthermore, ROTH IRAs beneficiaries will not pay taxes on the inherited ROTH account, neither income taxes when withdrawn nor taxes on gains accrued before withdrawal. It is only after the inherited assets are withdrawn (account must be emptied within ten years of inheritance) and IF the funds are reinvested will future investment income/gains be subject to tax. Also, because there are no RMDs, the inherited ROTH funds can remain invested for the full ten-year period and enjoy this tax-free legacy growth.

ROTH IRAs are even more attractive relative to traditional IRAs since the Secure Act 2.0 was passed in 2020. Before the Secure Act, beneficiaries of IRAs could stretch their mandatory withdrawals over their lifetimes which resulted in smaller withdrawals and less impact on resulting marginal tax rates. Now, after the Secure Act, Inherited IRA owners are required to empty the account with annual RMD withdrawals over ten years which could result in higher marginal tax rates over those years. Inherited ROTHs, while also required to be emptied within ten years, because withdrawals are tax free, do not face this income tax consequence.

If you have an IRA or 401k, especially if your assets are 401k/IRA-heavy, it could make sense to have your financial professional run a ROTH conversion optimization scenario so you can see if a ROTH conversion can help you achieve your lifetime financial and legacy goals.