Roth - To do or not to do?
26 Jul 2020 - Nuruddin Pethani
Photo Credit: Adeolu Eletu
“Why should we convert our IRA to Roth and pay the taxes now?” a client asked.
“My hospital gives me both the options to do Regular 401k or Roth 401k, which one should I do?” another client questioned.
As a CPA firm, we do get a lot of these questions every day. So, what is the answer?
There is no one suit or one dress fits all, but let’s take the different scenarios.
Background: A Traditional IRA or 401k gives you a tax deduction right now, but the money is taxable when you withdraw it at your retirement. A Roth IRA or Roth 401K plan you don’t get a tax deduction right now, but the growth is completely tax-free.
Scenario 1
Persons in their 20’s or early 30’s starting work:
In this scenario, there is a low probability the person is in the maximum tax bracket or the prime of his/her earning capacity.
It is better if that person starts contributing to a Roth 401K. The reason behind this is 2 fold:
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He/She is in the lower tax bracket right now.
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Since they are young, the money will grow tax-free for several years.
Scenario 2
Persons at their prime earning age or dual-income families:
These people are in the highest tax-paying bracket right now. There is a low chance that the tax bracket will be higher when they retire and they need all the tax deduction they can get.
In such a scenario, it seems obvious that you should invest in a regular 401k to get the maximum tax deduction right now.
The other point of view is that if you have savings for which there is no urgent need and you can afford to pay taxes now, pay it off and do Roth IRA and watch the money grow tax-free for years. There is also no minimum distribution rules for the money in Roth IRA.
Scenario 3
Persons near to Retirement age:
The people close to Retirement have to evaluate if there is a financial need for them to take the minimum distribution at age 72. Do they have enough savings in their non-IRA accounts and can do without taking out money from IRA’s?
If they need the Retirement money for the day to day living expenses then they are generally not in the top tax bracket. They should not convert to Roth IRA. Why pay the taxes now on the entire amount and be in a higher tax bracket.
Switching to Roth IRA is beneficial as the growth of your money can be tax-free. If you are planning to take out the money soon, then there is little long term benefit as there is a short time for your money to grow in the future.
If you do not need the IRA money right now then, you can think of converting Traditional IRA to Roth IRA. The best time to convert is when the market has dropped significantly and stocks are lower. You only pay taxes on the amount you convert; as per the market value at the time of conversion.
All future growth is completely tax-free on the converted amount. Other advantages are that you and your spouse do not have to take minimum distributions on Roth IRA. Your children can avoid withdrawing the money until 10 years after you are no more providing more tax-free growth.