The Seven Cases to do a Roth Conversion

Should your clients convert some of their traditional tax-deferred money (e.g. IRA or 401K) to an after-tax Roth account? Though I’m not related to the late, eponymous Senator William Roth, I spend a significant amount of time with my clients looking at this issue. There are some myths that are just plain wrong. Here is how to think about and frame the conversation with your clients.

I’ll conclude with the seven situations to consider for each client when advising on this issue.

Warning: I’ll start simple, but get to more complex situations – nothing about taxes is ever simple.

Roth versus traditional IRAs

The difference between a traditional and a Roth is as follows:

  • Traditional – get a tax deduction when you contribute but pay taxes when you take it out.
  • Roth – get no tax-deduction when contributed but it grows tax-free. You owe no additional taxes upon withdrawal.

It’s a decision of paying taxes now or later. And, of course, my analysis is based on current tax law and rates.

The three-bucket approach for tax-diversification

I’m not talking about three buckets of money for spend down, such as a “safe” bucket of cash to live on if stocks tank. I’m referring to three buckets of tax-wrappers to lower the risk of tax-law changes. These three buckets and their advantages are:

  • Taxable money. Capital gains taxes are typically lower than ordinary income and there is a step-up basis upon death.
  • Tax-deferred money. You get a tax-deduction immediately.
  • Tax-free Roth money. It grows tax-free and no RMD must be taken from this pot of money.

Let’s face it; none of us knows future tax law changes. Sure, I think tax rates will go up because of our huge debt and deficit (I’m not a believer in modern monetary theory), but logic doesn’t usually prevail when it comes to politics. I don’t know future ordinary income or capital gains tax rates, the future of the step-up basis upon death or even future estate tax exemptions. And all of those play a role in whether to contribute or do Roth conversions.

Because I know I don’t know the future, when a client asks whether they should save in taxable, tax-deferred, or tax-free, my answer is, “yes – all three.”