When to convert to a Roth IRA (if at all)? It’s an age old question akin to “Who’s on first?” without the comedy. Vanguard attempts an answer with a new discussion of best practices to consider.
“Many investors hold substantial tax-deferred retirement accounts such as traditional IRAs and 401(k)s,” the Pennsylvania-based investment behemoth rightly, if somewhat obviously, notes. “Depending on their goals, they may want to think about converting some or all of those assets to a Roth IRA.”
Discussions about conversions most commonly focus on retirement planning and expectations for current and future tax rates, it adds. However, Roth IRAs can also serve as a wealth transfer vehicle in an estate plan, helping individuals to achieve—or amplify—their wealth transfer goals:
With that, it offers the following three suggestions:
- Consider the potential to transfer greater after-tax wealth. When investors convert a traditional IRA to a Roth IRA, they are “prepaying” the income taxes for beneficiaries. Additionally, if an estate is large enough to be subject to estate taxes, the conversion removes the “double taxation” of these assets. Unlike those from tax-deferred accounts, distributions from a Roth account are not subject to income tax.
- Evaluate tax rates for investors and their beneficiaries. The potential benefits depend not only on the difference between the investor’s current and future marginal income tax rates but also on the beneficiary’s future tax rates. Realistically, future tax rates are uncertain in many cases, especially when planning across generations. The tax diversification benefits of a partial Roth conversion can help hedge that uncertainty.
- Capitalize on annual tax planning opportunities. Once an investor decides that a conversion is beneficial, he or she should take advantage of annual tax planning opportunities to maximize the benefit. Strategies we discuss include pairing partial conversions with charitable giving, making full use of low marginal income tax rates, taking Social Security income taxation into account, and planning within the Alternative Minimum Tax (AMT) envelope.
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
