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Roth IRA conversions gaining traction

Financial advisors recommend doing research before investing

By: Medora Lee
USA Today

..... Roth conversions to secure tax-free withdrawals during retirement are gaining popularity as Generation X gets closer to retirement, but financial advisers warn that the decision to convert should be carefully considered.
..... Roth conversions are asset transfers as a traditional IRA or 401(k) into a Roth IRA. People pay income tax on the converted amount in the year of the transfer, but the money grows tax-free and withdrawals during retirement are tax-free. Roth accounts also aren't subject during retirement to required minimum distribution and aren't taxable to heirs.
..... Since income taxes can be a retiree's largest expense, according to the Financial Industry Regulatory Authority, it's natural for people who have the bulk of their retirement savings in traditional 401(k) and IRA accounts to consider converting to Roth accounts.
..... Roth IRAs didn't exist until 1997, a decade or more after Gen X (born between 196 and 1980) started working, making it likely that most Gen X savings are in traditional accounts. conversions during the second quarter of 2024 rose 46% across all ages form the previous year, according to data from investment firm fidelity.
..... But "because of the nuance around each person's situation, you really need to do a full analysis and get the full picture to determine if a Roth conversion is appropriate," said Chris Berkel, investment adviser and president of AXIS Financial. "If you have two people with identical situations, except one variable, it could make a conversion sensible for one and not the other."

Can math determine if you should do a Roth conversion?

..... Typically, people compare their current and expected future marginal ax rates.
..... "The rule of thumb has been that higher future tax rates make a conversion more desirable, while lower ones make it less so," investment management firm Vanguard said in a report.
..... Financial advisers say that's good start, but Vanguard says the simple rule misses situations in which a Roth conversion can be beneficial even if your expected future tax rate falls. Instead, Vanguard promotes the "BETR." or break-even tax rate.
..... BETR is the future tax rate at which it makes no difference whether you convert or not. A person's future expected marginal tax rate is compared with BETR to determine whether a Roth conversion would be beneficial.
..... "In a sense, the decision hinges upon a single figure," vanguard said.
..... Here's how it works, Vanguard said:
* If it is 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 traditions IRA expects a lower 24% rate in retirement. The IRA is expected to triple to $300,000 over 20 years. Based only on tax rates, the person would skip a conversion on the expectation of paying a lower tax on withdrawals later. Using BETR shows a different story.
..... "Without a conversion, the balance would be $228,000 after paying the 24% tax, or $72,000, at withdrawal.
..... A Roth conversion would cost $35,000 or 35% in upfront taxes. Assume the $35,000 would have doubled to $70,000 after taxes had it remained invested. That lost growth would reduce the balance at the end of 20 years to $230.000.
..... Despite the lower expected future tax rate of 24%, the conversion would have yield $2,000 more, Vanguard said.
..... (Vanguard used this equation: $300,000 * [1 - BETR] + $230,000 and solved for BETR, which is 23.3%. since that;s lower than the 24% expected future tax rate, the person should convert.)

Is there more to consider when deciding on Roth conversions?

..... BETR "is a grate rule of thumb as a place to start," Berke said, "but it doesn't get into the weeds of someone's specific situation."
..... People also need to look at "soft" considerations, he said. Those could include how much is saved in taxed (e.g. brokerage or money accounts), pre-taxed (e.g. 401(k) or IRA) and tax-free (Roth or health savings) accounts. Future sources of income, such as traditional pensions, tax-free military benefits and Social Security should also be considered.
..... "Then, expenses need to be brought into the equation, like how much is going to be spent in retirement and any legacy goals," Berkel said. "Most people don't realize that leaving a large, pre-tax IRA to their children could force them to pay more in taxes as well. Some people might not care about this, but others may want to be conscientious of what their kids pay in taxes."
..... By law, most non-spouse IRA benefits must fully distribute the account by December 31 of the 10th year following the original owner's death. If the peons who died was already yakking required minimum distributions before death, the heir must continue taking annual RMDs and have the account depleted by the 10th year. Distributions are taxed as income. Inherited Roth accounts distributions aren't taxed as long as the account had been open at least five years.

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