In recent years, vast numbers of people have become eligible to consider Roth conversions. They include high-income people who were not eligible for Roth conversions prior to 2010 and millions of people who have become eligible to convert money to employer-sponsored Roth 401(k) accounts since they became available in 2006.
At least once every two years, financial advisors should have a “conversion conversation” with clients, to review and evaluate conversion options:
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From Traditional IRAs and SEP-IRAs to Roth IRAs
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From SIMPLEs to Roth IRAs, after two years of plan participation
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From employer-sponsored plans to Roth accounts offered within these plans
The conversation need not be complex or lengthy, because there are just four key points that usually prevail in conversion decisions. Here's the conversation, in a nutshell:
“Mr. and Mrs. Client, if you would like to consider converting part or all of your plan money to a Roth, there are four key issues you should evaluate.
Key #1 – Liquidity – To make the conversion work, you generally need enough liquidity to avoid tapping the Roth IRA for at least five years. To keep all your retirement plan assets working, you may want to pay the income taxes (on the conversion) with other money.
Key #2 – Income Tax Rates – If you think income tax rates will go higher in the future, a conversion can be attractive because it lets you lock in today's tax rates. It's important to plan conversions so that they don't push your taxable income into a higher bracket, or subject your net investment income (excluding retirement plan income) to the 3.8% Medicare tax.
Key #3 – Retirement Freedom and Flexibility – How do you want to spend retirement? Choice A: You can estimate the required minimum distributions due each year (after age 70 ½). Choice B: You can write yourself a tax-free check from your Roth if and when you need it, and never face a required distribution as long as you live. How important is the quality and simplicity of retirement living for you?
Key #4 – Leaving Your Heirs “No Tax Strings” – With a Roth conversion and a little planning, you can make sure your beneficiary inherits an IRA with no income tax strings attached. This is opposed to leaving the beneficiary a Traditional IRA or 401(k) that could be fully taxable as ordinary income.
To brush up on the rules for Roth conversions, you may want to check the IRS FAQs on Roths.
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