As Gen X approaches retirement, many are considering Roth IRA conversions to secure tax-free withdrawals. But should you convert? Financial advisers warn that the decision should be carefully considered. Roth conversions involve transferring assets from a pre-tax retirement account, like a traditional IRA or 401(k), into a Roth IRA. While you pay income tax on the converted amount upfront, the money grows tax-free, and withdrawals during retirement are also tax-free. Roth accounts also avoid required minimum distributions (RMDs) and are not taxable to heirs.
Since income taxes can be a retiree's largest expense, many Gen Xers with traditional 401(k) and IRA accounts are considering the switch. According to Fidelity, conversions during the second quarter of 2024 rose 46% across all ages from the previous year. However, Chris Berkel, an investment adviser, emphasizes the need for a full analysis to determine if a Roth conversion is appropriate. He notes that even two people with identical situations could benefit differently from a conversion, depending on one variable.
Math can help determine if a Roth conversion is right for you. Typically, people compare their current and expected future marginal tax rates. A higher future tax rate makes a conversion more desirable, while a lower one makes it less so. However, Vanguard promotes the "BETR" or break-even tax rate, which is the future tax rate at which it makes no difference whether you convert or not. BETR can be calculated using Vanguard's Roth BETR calculator.
Here's how BETR works: If the future tax rate is at BETR, conversion would not make a difference. If it's below BETR, conversion would make the investor worse off. If it's above BETR, conversion is the better option. For example, a person in the 35% marginal tax bracket with $100,000 in a traditional IRA expects a lower 24% rate in retirement. Using BETR shows that a conversion would yield $2,000 more, despite the lower expected future tax rate.
However, there are more factors to consider when deciding on Roth conversions. "BETR is a great rule of thumb as a place to start, but it doesn’t get into the weeds of someone’s specific situation," says Berkel. People also need to look at "soft" considerations, such as how much is saved in taxed, pre-taxed, and tax-free accounts. Future sources of income, like traditional pensions and Social Security, should also be considered. Expenses, such as retirement spending and legacy goals, are also crucial. "Most people don’t realize that leaving a large, pre-tax IRA to their children could force them to pay more in taxes, too," Berkel notes.
In conclusion, while math can help determine if a Roth conversion is right for you, it's essential to consider all the factors involved. By carefully weighing the pros and cons, you can make an informed decision about whether to convert to a Roth IRA.
