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Financial experts often recommend including a Roth IRA in your retirement plans. Even if you don’t currently have a Roth IRA account, it’s not too late. You might still be able to capitalize on the benefits of this account using a Roth conversion. There are a few things you need to know, though, before you consider converting some of your traditional IRA assets to a Roth account. In this article, we will outline the benefits of a Roth conversion and how to determine if one is advantageous to your financial needs.
What is a Roth conversion?
A Roth conversion is when an IRA account holder decides to convert some or all of their IRA account into a Roth IRA account.
Unlike traditional IRAs, Roth IRAs’ distributions are tax-free once you reach past the age of 59 ½. However, when you convert funds from a traditional IRA to Roth IRA funds, account holders must pay federal and state income taxes on the conversion amount. After you pay these taxes on the distribution amount, your Roth account can continue to grow tax-free.
Advantages of a Roth conversion
There are several reasons why a Roth conversion may be advantageous. Keep in mind; however, that not all benefits may apply to your specific situation. Therefore, before moving forward with a Roth conversion, it’s wise to consult with a financial planner. A financial planner can help you see all the possible advantages and disadvantages of this decision.
No income restrictions
Not every taxpayer can contribute to a Roth IRA. Those who are high-earners and those who don’t earn any income are not eligible to contribute to a Roth account. The IRS determines eligibility for contributions based on your modified adjusted gross income and tax filing status. As of 2020, if you’re single and your MAGI surpasses $139,000 or $206,000 if you’re married and file jointly, you cannot contribute to a Roth account. Everyone outside those parameters can contribute up to $6,000 per year and $7,000 per year if you’re over 50 years old.
There are no income restrictions on Roth conversions, however. In other words, you can contribute to an IRA and then convert it to a Roth, which some experts call a “backdoor” Roth IRA.
Current tax rates
Keep in mind, a Roth account isn’t always the most suitable solution. Sometimes an IRA makes more sense, even for those who earn a higher income. Experts recommend Roth IRAs for those who anticipate a higher tax rate in retirement. They suggest this to Roth account holders because they may be taxed on contributions now and then receive tax-free withdrawals in retirement. Generally, a traditional IRA may have more value for a high-earner since their income levels drop in retirement.
On the other hand, the current tax brackets are the lowest they have been in decades. Unless Congress steps in, these tax rates will retire in 2025. Therefore, if there’s a chance your tax rate may increase in the near future, the argument for a Roth conversion is more compelling.
A lifetime of tax-free growth
The IRS requires traditional IRA account holders to take required minimum distributions (RMDs). Every year after an account holder turns 72, or age 70½ if you reached age 70½ before 2020, they must take a distribution. Even if the account holder doesn’t need the money, they still must take regular distributions. As a result, account holders lose tax-free growth when they take distributions.
For 2020, the CARES (Coronavirus Aid, Relief, and Economic Security) Act provides a temporary waiver of the RMDs. So, if you have RMDs but don’t want to take them this year, you don’t have to. Conversely, the IRS doesn’t require Roth account holders to take distributions. Therefore, if you have a Roth IRA, you can continue to keep it in your account and accumulate tax-free growth.
Minimize the tax burden for your heirs
While Roth IRAs do not have RMDs for account holders, they do have them for their heirs (excluding the spouse). If you don’t need the money and want to leave funds to your heirs, a Roth conversion will help them get a better deal.
Until the passing of the SECURE (Setting Every Community Up for Retirement Enhancement) Act in 2019, non-spouse beneficiaries could “stretch” RMDs over their life expectancy. Now, the SECURE Act mandates that these beneficiaries must distribute the account 10 years after the account holder’s death. The advantage of converting the funds to a Roth is the distributions will be tax-free.
How to determine the right amount to convert
When determining the right amount to convert, there are two things to consider. First, depending on the amount you withdraw, it could put you into a higher tax bracket. Since conversion amounts are added to your taxable income, your tax obligation could increase during the year of conversion. To stay in your current tax bracket, you can only convert the difference between your current tax bracket’s highest income and your pre-conversion taxable income.
For example, let’s say a married couple that’s filing jointly has a taxable income of $100,000 and is in the 22% tax bracket. They can convert up to $71,050 without entering into the 24% tax bracket since it begins at $171,050.
This couple can also choose to spread out the tax burden of the conversion since the total amount is often steep. If the same couple took a $71,050 conversion, they might owe $15,631 in taxes. But, any tax deductions may offset the tax burden of the Roth conversion.
You can use donations to qualified charities as a tax deduction, for instance. However, it’s important to note that if your itemized deductions do not exceed the standard deduction amount, this strategy won’t lower your tax burden. Therefore, consult with a tax advisor and financial planner to determine what deductions may offset your tax liability.
Also noteworthy is that if you use the funds from your IRA to pay for the taxes on your conversion, the IRS views these funds as a distribution. Therefore, if you’re under age 59 ½, you would also have to pay a 10% early withdrawal penalty on the entire amount.
Is a Roth conversion right for you?
So, is a Roth conversion right for you? It depends on you and your unique situation. If you are now thinking about how to take the plunge, please consider some of these questions:
Will your tax bracket be higher in retirement?
When considering a Roth conversion, you need to assess if you think your tax bracket will change over the next few decades. If you believe your tax rate is lower now, a conversion is a promising solution. This is because you will pay less in taxes now than you would if you took distributions later.
On the other hand, if you believe your tax burden will be less in retirement, the tax savings of a Roth conversion may not make sense at this time.
Will you need the funds within the first 5 years of the conversion?
Roth accounts have a 5-year holding period on distributions. So, even if you have a Roth conversion, you have to wait 5 years from opening the account to make any withdrawals. Therefore, if you think you may need the money right away, this may not be the best option.
What are the short-term and long-term consequences of a conversion?
To reiterate, when you convert an IRA to a Roth account, you will owe taxes on the entire distribution amount. Also, the money spent on taxes takes away from the compound interest that will grow your IRA. So, in this scenario, you may have less money when you reach retirement.
The bottom line
Ultimately, a Roth conversion’s advantages depend on the situation. The best way to learn if a Roth conversion is right for you is to consult with your financial planner. A financial planner will develop a tailored financial plan to maximize your savings and help you achieve your retirement goals.
If this appeals to you and you’re looking for a financial planning partner who can help you realize your retirement goals, we have offices located in Redmond, Mill Creek, the Tri-cities region, and Denver. Our firm’s experience helps retirees and those preparing for retirement achieve financial freedom by forming a plan that outlines how to obtain the income you need and want until you turn 100.
If you’re ready to take the first step toward achieving your retirement goals, our team is ready to assist you. We’ve helped hundreds of couples, as well as individuals, transition into retirement with confidence, and we’d like to do the same for you.
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