Using In-Plan Roth Conversions to Maximize Your Retirement Savings

Why is an in-plan Roth conversion an opportunity for retirement investors?

A traditional retirement account defers taxes until the funds are withdrawn at a future date. Conversely, a Roth account taxes contributions upfront, not upon withdrawal, provided certain conditions are met.

Through an in-plan Roth conversion, you can transfer some or all of your vested funds from a traditional retirement account to a Roth account. This conversion triggers a tax liability on the converted amount in the year of the conversion. However, once the funds are converted to the Roth account, they will benefit from tax-free growth. In addition, during retirement, retirees can make tax-exempt withdrawals if they meet certain conditions.

In essence, an in-plan Roth conversion involves transitioning vested funds from one account type to another to secure tax-free withdrawals in the future while incurring tax liabilities at the time of conversion.

Key Considerations

In-plan Roth conversions provide tax diversification benefits by allowing investors to convert their traditional retirement accounts into Roth accounts. This conversion can be advantageous because Roth accounts offer the potential to withdraw tax-free income in retirement. By converting to a Roth account, investors can reduce their future taxable income. Additionally, tax-free withdrawals from Roth accounts can provide a clearer source of income during retirement, helping to maximize overall financial security and reduce the headaches of calculating post-tax distributions.

If tax rates increase, investors can use Roth conversions to hedge against higher future taxes by converting traditional retirement accounts into Roth accounts when current tax rates are lower. This strategy can help reduce potential tax liabilities in retirement, as the converted funds will grow tax-free and can allow tax-free withdrawals. By taking advantage of current lower tax rates, investors can essentially lock in those rates and avoid paying potentially higher taxes in the future. This approach provides a valuable opportunity to manage and minimize tax burdens during retirement.

Additionally, unlike traditional accounts, Roth accounts do not have Required Minimum Distributions (RMDs) during the account holder's lifetime. This means that the funds in a Roth account can continue to grow tax-free for a longer period. Without the need to withdraw a certain amount each year, investors can maximize the growth potential of their retirement savings.

Another important consideration is timing. A potentially favorable time for an in-plan Roth conversion is during a market correction. When the market is down, the value of your portfolio is lower, reducing the tax expense when converting assets from a traditional account to a Roth account. Conversely, if you convert during a market peak, you might pay an inflated amount of taxes. The in-plan Roth conversion also allows participants to convert their traditional account into a Roth account periodically. This could be a favorable strategy when markets are volatile as it helps minimize taxes by smoothing the conversion values of the portfolio.

While in-plan Roth conversions offer numerous benefits, they also have some disadvantages that warrant careful consideration. For example, the converted amount is deemed taxable income for the conversion year, potentially elevating your tax bill in that year and pushing you into a higher tax bracket. Additionally, if you are seeking financial aid for education, the increased taxable income could negatively impact your eligibility. Furthermore, a significant uptick in taxable income could result in the loss of certain tax deductions or credits. It is also essential to ensure that you have adequate funds to cover your tax liability, as retirement plan funds cannot cover this expense.

Examples

The following examples show two scenarios: one in which an in-plan Roth conversion is favorable and another where it is unfavorable.

Scenario 1: Favorable In-Plan Roth Conversion
Assumptions:

• Initial balance in the traditional retirement account: $100,000
• Annual growth rate: 5%
• Years until distribution: 20 years
• Current tax rate for conversion: 22%
• Future tax rate at distribution: 30%

After a 20-year time horizon, the net (after-tax) balance of this account would be $206,957.22 if converted to Roth or $185,730.84 if the assets remain in the traditional account. Exercising the in-plan Roth conversion saves $21,226.38 — a significant difference. This is due to the lower current tax rate for conversion compared to the higher tax rate that will be applied at distribution.

Scenario 2: Unfavorable In-Plan Roth Conversion
Assumptions:

• Initial balance in the traditional retirement account: $100,000
• Annual growth rate: 5%
• Years until distribution: 10 years
• Current tax rate for conversion: 40%
• Future tax rate at distribution: 22%

In this scenario, holding the assets in a traditional account until distribution in 10 years is preferable. If the assets are held in a traditional account, the net (after-tax) balance, upon distribution, would be $127,053.78. If the assets are converted to Roth, the net (after-tax) balance upon distribution would be $97,733.68 ($29,320 less). This is due to the higher current tax rate for conversion compared to the lower future tax rate at distribution.

In the simplistic example shown above, the main drivers of value creation and/or degradation are the differences between current and future tax rates, as well as the time required to withdraw. Higher future tax rates and a long time period until withdrawal favor in-plan Roth conversions. The opposite is true in the case of lower future tax rates and a shorter time period until withdrawal.

Conclusion

In-plan Roth conversions represent a valuable strategy for retirement savers looking to diversify the tax treatment of their retirement plan distributions. However, before converting your eligible savings to a Roth account, there are two important questions to consider with your tax advisor:

1. How will you pay the taxes on the conversion? You will be responsible for paying taxes on the amounts converted to Roth. Since income taxes are not withheld at the time of the conversion, you must set aside funds outside of your retirement plan to cover the tax payment.
2. Will you benefit more from paying taxes now or later? In general, the more time you have until retirement and if you anticipate your tax rate to rise, the greater the potential benefit of having Roth assets.

Answering these two questions will help you determine whether or not an in-plan Roth conversion would be a good strategy for you to consider. As always, be sure to consult your tax advisor for the best approach for your unique situation.

Hypothetical Roth Conversion Calculator

Ian Gilbert is an analyst assistant on the Research and Retirement Plan Teams. His responsibilities include monitoring investment products and strategies, creating deliverables for Innovest’s retirement plan clients, and completing quarterly performance reports.

Tomas Jansson is a vice president and consultant at Innovest Portfolio Solutions. As a member of our Retirement Plan Practice Group, he focuses on helping companies design, optimize, and govern the retirement plan benefits they offer their employees.

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.

Read more articles by Ian Gilbert, Tomas Jansson