Roth Conversions: Is it right for me?
Why convert a traditional IRA/401k to a ROTH IRA?
What is the difference between a traditional IRA and a ROTH IRA? What IS a ROTH Conversion?
Traditional retirement accounts (traditional IRAs or traditional 401ks) are tax deferred accounts (taxed later!)...this means you get to reduce your taxable income in the year you contribute to the traditional IRA but will be taxed at a later time once you start taking distributions from this account.
ROTH IRAs are tax exempt accounts (tax free!)...this means you do not get a deduction when contributions are made but the contributions, earnings, and future distributions are never taxed again assuming you follow a few simple rules.
ROTH Conversions occur when you move your retirement money from a traditional retirement account to a ROTH IRA. You will then be paying taxes on those conversions in that year. Ideally the taxes will be paid out of your bank account or a non retirement account. If you pay the tax out of the retirement accounts then you are reducing the maximum amount that can be moved into the ROTH and also potentially paying a penalty if under 59.5yrs old. Now that we have these three definitions in place let's move on to the Pros & Cons.
We are going to walk through the pros and cons of ROTH conversions. Every situation is personal but this will be a good starting point to get you thinking about whether a ROTH conversion could be right for you.
Pros: Possible Reasons to Convert/ROTH
● Low Current Tax Bracket
● No Required Minimum Distributions!
● You Decide When and How much
● Grows Tax Free
Low Current Tax Bracket...no one knows what is going to happen with taxes but if you are currently in a low tax bracket and believe taxes will be higher down the road then this could be a good option. Are you in the 10% or 12% tax bracket now and expect to go into a higher tax bracket once you start accessing your retirement funds or claim social security? This could certainly be the case for someone who has recently retired but is delaying the claiming of their social security. This is usually an optimal window for ROTH Conversions.
No Required Minimum Distributions (RMDs)!...If you have already paid your taxes on your retirement account (ROTH!) then the government no longer requires you to take it out at a certain age. This gives you the ultimate flexibility on deciding when and how much to take out of your account without impacting your tax bill. RMDs can cause a huge tax bill...think about a married couple who is in their early 60s and has 2 mm in traditional retirement accounts...if they wait for their RMDs at age 73 this could bump up their taxable income by over 100k. When you add that to their Social Security income, this could bump them into an even higher tax bracket.
You Decide When and How Much... In this scenario you have the opportunity to decide when and how much you are going to pay vs waiting for the unexpected...what I mean by this is you (and me!) don’t know what is going to happen to tax laws going forward. By strategically converting some of your traditional IRA assets into a ROTH, you will have the opportunity to know exactly how much you will be paying.
Grows Tax Free...There aren’t a lot of account types that grow tax free and allow you to take distributions tax free. This is one of them! This could help create a tax free income stream in retirement. If the money is meant as a legacy for kids or grandkids, this is also an opportunity to be able to transfer assets where the taxes have already been paid.
Cons Converting/ROTH Cons
● High Current Tax Bracket
● Paying Taxes Now
High Current Tax Bracket...If you are in a high tax bracket, ROTH conversions will not help this issue and will actually cause your taxable income to increase and thus pay more taxes at a potentially higher rate. One caveat to this is that we don’t know what tax rates will be in the future. If we knew (and we don’t!) that tax rates were going to increase in the future, then it still could make sense for someone to convert even if they are in a relatively higher tax bracket.
Paying Taxes Now...Converting to a ROTH causes your tax bill to increase in the year you convert. Ideally you would not want to pay the associated tax bill from the conversion out of your retirement accounts. Why? Because this lowers the maximum amount you can put into your ROTH. If you pay from a taxable brokerage or a bank account then you are maximizing the ROTH conversion. With that being said, this will take down the amount of available cash from your other accounts.
Lastly, ROTH conversions could be a great way for you to thoughtfully move your accounts from a traditional retirement account (tax deferred) to a ROTH (tax free). Please let us know if you have any questions around ROTH conversions. Working with a financial planner and/or your tax advisor on the timing of your conversions and mapping out a proactive strategy to pay the taxes that are due in your traditional retirement account, will go a long way into helping you maximize your retirement.
