Roth IRA conversion is currently a popular topic in financial planning, but many people are not sure whether a Roth IRA conversion is right for them. A Roth IRA conversion should be evaluated as part of your overall financial plan to see if the conversion improves the results of your plan. Whether a Roth IRA conversion will improve the results of your overall financial plan depends on both future income tax rates and future investment performance. Let’s review both of these factors and how they affect the attractiveness of a Roth IRA conversion.
For any tax-deferred IRA assets you convert to a Roth IRA, you must pay income taxes on those assets at the time of conversion. For any IRA assets you do not convert, you can continue deferring income taxes on those assets and pay the income taxes when you withdraw those assets in retirement. So from strictly an income tax perspective, a Roth IRA conversion would appear unfavorable if your income tax rates before retirement are higher than your income tax rates during retirement. On the other hand, a Roth IRA conversion would appear favorable if your income tax rates before retirement are lower than your income tax rates during retirement.
In regards to investment performance, there is a positive correlation between performance and the attractiveness of a Roth IRA conversion. Paying income taxes on a Roth IRA conversion will reduce your total current assets, so the investment growth of your converted assets must be enough to recover the taxes paid on the conversion. A Roth IRA conversion would appear unfavorable if the investment growth of your converted assets is less than the amount of taxes you paid on the conversion. On the other hand, a Roth IRA conversion would appear favorable if the investment growth of your converted assets is greater than the amount of taxes you paid on the conversion.
Since future income tax rates and future investment returns are very unpredictable, we cannot know for sure whether a Roth IRA conversion will ultimately be beneficial to the overall financial plan. What we can do is make assumptions and identify scenarios where a Roth IRA conversion would be beneficial or detrimental to the plan. If we are willing to consider the past to provide a basis for what could happen in the future, we may also be able to assign probabilities to different scenarios. However, we should remember that anything is possible, and the decision of Roth IRA conversion is ultimately based on your expectations for the future
