When is a Roth IRA conversion right for me, asked a pre-retiree recently. Well, it depends. And while never a satisfying answer, it is a personalized decision based on many factors.
Let’s say you’re in a similar position as this pre-retiree who asked this question in an online financial advice forum recently. She’s age 62, currently receiving a taxable pension of $1,500 per month and now self-employed as a home child care provider netting about $500 per month. She has a mortgage of $67,000 remaining, a fixed annuity with a balance of $31,000 and is regularly contributing $250 per month to savings.
Right now, she has a traditional IRA managed with a balance of $87,148 at a Big Box firm at a cost of $280 per quarter. “It’s costing me more than the growth of my money which is now at a low point,” she added.
She noted that all her living expenses were covered by her current pension. But she also planned on applying for her Social Security benefit later this year.
Insights from the Money Coach – Steve Stanganelli
Clearly, she has a lot of moving pieces so I strongly suggested that she – and anyone – consult directly with a fiduciary financial planner to help go through the process.
But I think that she may be confused about the difference between the two types of Individual Retirement accounts and how to coordinate her tax and cash flow situation with her Social Security benefits.
Generally, I suggest that individuals approaching retirement take a look at the projected retirement lifestyle expenses (especially medical costs) and model how they expect to cover these from cash flow and investments. Taxes are certainly an important factor but for someone in this tax bracket not a sufficient reason to go through the cost of a conversion.
Let’s take a deeper look.
In your original question, you mention converting your traditional IRA to a Roth IRA. First, a little background. In a traditional IRA, you pay taxes on the money you withdraw because it was funded with before-tax money (from IRA contributions or 401k employee deferrals). In a Roth IRA, you get to make your withdrawals and not pay any tax on the distributions. Another nice feature is that you are not required to take minimum distributions (called RMDs) like you are with a traditional IRA.
But in order to make this conversion, you will need to pay the tax man his due before you get these benefits. And the question is, Where will the money come from to pay the income taxes due at the time of conversion? Let’s take a back-of-the-envelope calculation here. If you’re in a low tax bracket (let’s say marginal rate of 10%), you may need to come up with $8,700 more or less for federal taxes plus possible state income taxes.
You might consider using the principal in your IRA to pay for this. But that sort of defeats the purpose of doing the conversion. Your remaining investment has to work harder to get back to where it was before the conversion just to break even with the ‘cost’ of the taxes.
You’d be better off using funds from outside the IRA to pay the taxes. But if you did have such funds, I would be concerned with whether or not this drains your emergency cash reserve.
One of the reasons that folks opt for Roth IRAs is that you can get ‘tax diversification’. There’s an assumption that many who retire will be in lower tax brackets after retiring than they were in before. But folks may also be rightly concerned that in order to close the gap on persistent budget deficits, Congress may choose to raise tax rates even on those in retirement. So a Roth is one way to cover your bases and lock in lower tax rates now. You’re making a bet that tax rates in the future for your bracket and situation may be higher so you pay a little now to avoid paying more later.
But given what you’ve described in your question, you’re not in a high tax bracket now.
And you mentioned that you’re planning on taking your Social Security benefit now at age 62. If you opt to take your benefits early, you’re leaving a big chunk of cash on the table. For every year before your Full Retirement Age (which is probably 66), your benefit is 8% lower … per year. So you’re locking your future benefits in at a lower rate … in your case probably about 1/3 less per year for life.
(Let’s not discount the impact of inflation on your other expenses and the fact that you can get a Cost of Living Increase on your Social Security benefits starting at a higher base if you wait).
If your expenses are already covered by your pension and you have self-employment income and this additional amount of $250 per month from the bank (not sure what that is though), you’re better off holding out and not claiming Social Security. At the very least, you should get educated about your options. You can find some of this available through the Social Security website or www.MySSA.gov.
One other issue to consider is the potential for having Social Security benefits withheld. If you’re claiming before your full retirement age (and at age 62 you are), you will have $1 in benefits reduced for every $2 in income you earn above certain limits (used to be $14,160/year).
As to the issue about the cost of managed services through Fidelity, I believe that may be the least of your issues. The cost works out to be about 1.25% per year which is rather reasonable for what it is. You’re paying Fidelity to choose the investments and rebalance them periodically. Research indicates that 90%+ of the success of a portfolio is explained by the asset allocation and rebalancing decision. And most consumers will not likely do this on their own.
Now, you may not be getting “growth” of your money depending on what Fidelity is including in your investment mix. And that mix is based on your personal situation and risk profile. If you haven’t updated your risk profile with Fidelity, they may be investing for you in a way that is not appropriate for your age, risk tolerance, goals and changed income and job situation. So you should start with a call to their client service line to update this and see if this affects the portfolio they choose for you. My guess is that it will.
Your alternative is to find a different lower-cost provider. There are a number of automated investing service platforms that offer globally-diversified portfolios that are automatically rebalanced for costs anywhere from 0.25% to 0.75% per year. Even some advisors (like myself) use such services for clients saving them easily 40% per year in expenses.
Separately, I noted that this client – like many who are in retirement – may benefit by putting into place a government-insured Reverse Mortgage. If cash flow is tight, you may be tempted to take Social Security ‘early’ but that permanently reduces lifetime benefits. With a Reverse Mortgage, you can reduce the monthly cash outflow, use Home Equity Conversion Mortgage (HECM) proceeds to supplement cash needs, wait until you can get your full Social Security benefit and delay tapping into the IRA – regular or Roth.
So how and where you’re invested as well as how you look at your retirement cash flow options will probably be more important and meaningful to most investors than whether you retain a traditional IRA or convert to a Roth IRA.