April 8, 2024
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To Convert or Not to Convert

When it comes to the subject of conversion to Judaism, the Talmud in Mesechet Yevamot states the following: “When someone nowadays presents himself for conversion, we say to him: ‘Why do you wish to convert?…’” The Talmud takes a decidedly skeptical view of the prospect of a gentile converting to Judaism.

In a very different context, thought leaders in personal finance have disparate views about the soundness of converting from a traditional IRA to a Roth IRA. When a client asks me whether they should choose to convert, I advise emphatically: “It depends.”

 

Background

Decades ago, Congress created an opportunity for savers to put away money for retirement in investment vehicles like traditional IRAs whereby individuals can take a tax deduction for their contribution and watch their portfolios grow tax-free for many decades. The IRA (as well as 401K plans, 403B plans, etc.) has emerged as one of the most prolific savings vehicles for individuals with no other pension or retirement plan sponsored by their employer.

The Roth IRA was an option created in Congress in the Taxpayer Relief Act of 1997 and went into effect in 1998. While contributions to a Roth IRA are not tax-deductible, the portfolio grows tax-free, similar to a traditional IRA. But unlike the eventual distributions from a traditional IRA, distributions from a Roth IRA are tax-free as long as one has met the requirements. As an added bonus, there is no requirement to take an annual minimum distribution, unlike with the traditional IRA. Thus, a Roth IRA cannot only help individuals save for retirement, but it can also serve as a very efficient way to grow assets tax free for one’s entire life.

With these two significant advantages of a Roth IRA over a traditional IRA, why doesn’t one just convert all his/her assets into a Roth IRA?

 

The Downside of Converting

The primary drawback of a Roth IRA conversion, and the main issue from a cash flow standpoint, is that a Roth conversion results in a taxable event in the tax year of the conversion. While the conversion can be stretched out, and the tax impact can be spread out over time, many could be in the midst of their peak earning years, which could push their income into a higher tax bracket.

 

And the Upside

There are several positive features of a Roth IRA that make a conversion an effective tool for growing wealth tax-free. The first consideration is that despite a tax bite in the year of the conversion, the growth in the portfolio will generally be sheltered from tax for the rest of one’s life and beyond. Once the account is in place, there is no requirement for the account holder to take any distributions. And if one takes a distribution, it is usually completely tax-free.

Secondly, under current tax regulations, traditional IRA owners are compelled to begin taking annual taxable distributions at age 73, even if the account holder does not need those distributions to maintain his/her lifestyle. With the Roth IRA, the account holder can leave those assets growing tax free as long as desired.

 

Legacy Planning

Another advantage of the Roth IRA over the traditional IRA occurs after one’s passing. Children who inherit your traditional IRA are currently required to withdraw all assets in the IRA within 10 years. In many cases, this could be a period of time when your children’s income is peaking. Thus, the after-tax value of that inheritance could be significantly impacted. With regard to the Roth IRA, your children will also need to exhaust the account within 10 years. But on the positive side, they will have much more flexibility as to the timing of those distributions since there will be no tax liability.

 

Tax Uncertainty Down the Road

For many years, there was a consensus view in the financial planning community that the traditional IRA was a “no-brainer” in light of the fact that the benefit of the tax deduction at the time of contribution was more impactful than the tax paid upon distribution in retirement. Part of that thesis was that one’s tax bracket at the time of contribution could be significantly higher than one’s tax bracket in retirement. Thus, the tax savings today could be invested and help offset tax payments of future distributions.

My first observation is that many of our clients are finding that due to the substantial accumulation of wealth and investment assets in their working years, there is not necessarily a meaningful decline in their income tax bracket in retirement.

My second observation is that income tax rates are currently at historically low levels. In the meantime, worries about the burgeoning Federal budget deficits are likely to become an area of increasing concern to lawmakers, who could begin rolling back some of the previous tax cut legislation. Thus, federal tax rates in the future may become increasingly similar to the rates for high income earners today, making a Roth IRA a far more effective tool for preserving wealth over the long term.

 

Different Strokes for Different Folks

As with any financial plan or strategy, the optimal choice for whether to convert one’s traditional IRA to a Roth IRA may not be so obvious or a “one size fits all” situation. Generally, I recommend that one considers this choice in the context of one’s overall financial position and objectives. Please do not hesitate to contact me at [email protected] should you have any questions about this topic.

Investment Advisory Services are offered through Mariner Independent Advisor Network (MIAN), an SEC Registered Investment Adviser. Caplan Capital and MIAN are not affiliated entities. Some information provided herein has been obtained from third party sources deemed to be reliable as of the date of original publication, and rules, laws and legislation are subject to change without notice. This article should not be considered personalized advice, and it is important that your unique circumstances be taken into consideration prior to making any financial decisions.


Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm Caplan Capital Management, Inc., with offices in Highland Park and Hackensack. He holds a B.A. from Yeshiva University and an MBA in finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.

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