Roth Conversions: The Basics and Benefits
The Roth conversions is a valuable strategy that has many benefits including reducing your future tax burden, controlling your future income, and bequeathing tax-free assets so your heirs don’t have a tax burden. This strategy involves moving funds from a traditional IRA to a Roth IRA. In this post, I’ll explain how a Roth conversion works and what factors we need to consider to determine whether it’s the right choice for you.
Traditional IRA vs Roth IRA
First, let's review what a traditional IRA and a Roth IRA are. A traditional IRA is a tax-deferred account, which means that you don't have to pay taxes on the contributions you make or the earnings that accumulate in the account until you withdraw them. At that point, you'll pay taxes on the full amount of your withdrawal at your ordinary income tax rate. A Roth IRA, on the other hand, is a post-tax account. This means that you pay taxes on the contributions you make upfront, but you don't have to pay taxes on the earnings that accumulate in the account or the withdrawals you make during retirement.
So, what is a Roth conversion, and how does it work?
A Roth conversion is the process of moving funds from a traditional IRA to a Roth IRA. When you do a Roth conversion, you will need to pay taxes on the amount you convert in the year that you make the conversion. The tax bill will be based on your ordinary income tax rate. However, once the funds are in the Roth IRA, you won't have to pay taxes on any of the earnings or withdrawals you make from the account, as long as you meet the eligibility requirements.
One of the key benefits of a Roth conversion is that it can provide significant tax savings in retirement. Because you pay taxes on the converted amount upfront, you won't have to pay taxes on the withdrawals you make from the Roth IRA during retirement. This can be especially beneficial if you expect your tax rate to be higher in retirement than it is now. Additionally, because Roth IRAs don't have required minimum distributions (RMDs), you can keep your money in the account for as long as you like, allowing it to grow tax-free.
However, a Roth conversion is not suitable for everyone. To determine whether it's the right choice for you, we need to consider several factors, including your current income, deductions, credits, and tax bracket. We also need to consider your expected tax rate during retirement. This is because the amount you pay in taxes on the converted amount will depend on your ordinary income tax rate for the year in which you make the conversion. If you expect your tax rate to be higher in retirement than it is now, a Roth conversion may make sense. Conversely, if you expect your tax rate to be lower in retirement, it may make more sense to delay the Roth conversion.
True Marginal Tax Rate
To determine whether a Roth conversion is the right choice for you, we need to calculate your true marginal tax rate. This is the tax rate that applies to the next dollar of income earned, including any converted funds from a traditional IRA to a Roth IRA. It's different from your average tax rate, which is calculated by dividing the total taxes paid by total income. Calculating your true marginal tax rate involves taking into account your current income, deductions, credits, and tax bracket, along with other factors. Financial planners and tax professionals can utilize tax planning software to determine your true marginal tax rate.
Another factor we need to consider is the equivalency principle. This principle states that the net after-tax value of a traditional IRA and a Roth IRA should be the same if the tax rates remain constant. In other words, if you pay the same amount of taxes on your traditional IRA withdrawals during retirement as you would pay on your Roth IRA withdrawals, the after-tax value of both accounts should be the same. The equivalency principle is important to consider when deciding whether to do a Roth conversion because it can help you determine whether the tax savings from a Roth conversion outweigh the tax benefits of a traditional IRA.
In addition to your current and expected tax rates, we also need to consider other factors, such as your retirement goals, investment strategy, and overall financial situation. For example, if you plan to leave a legacy for your heirs, a Roth IRA may be a better option because it doesn't have RMDs and can continue to grow tax-free throughout your lifetime and the lifetime of your beneficiaries. On the other hand, if you need to use your retirement savings to generate income during retirement, a traditional IRA may be a better option because you can take advantage of the tax-deferred growth and the ability to withdraw funds without penalty before age 59 ½.
No Going Back
It's also important to note that a Roth conversion is an irreversible decision. Once you convert funds from a traditional IRA to a Roth IRA, you can't change your mind and move the funds back to the traditional IRA. Therefore, it's important to make sure that a Roth conversion aligns with your long-term financial goals and retirement plans.
Here are some considerations for Roth Conversions:
Are you taking social security? Adding more income could make more SSI taxable.
Will a conversion push you into a higher tax bracket?
Can you reduce your income to allow more room to convert more funds?
Has your account value fallen? Allows you to convert a higher percentage of your assets.
Will your RMD force you into higher tax brackets, make more of your SSI taxable, and/or trigger Medicare IRMAA while in retirement?
Can you leave tax-free assets to your heirs? Will they be in higher tax brackets when they inherit your assets? Your assets could put them in a tough tax situation.
Are your beneficiaries “Non-eligible Designated Beneficiaries”?
Do you plan on making Qualified Charitable Distribution? i.e. gifting IRA assets to a charity.
Do you expect to be in a lower tax bracket now or in the future?
Will you need distributions from your Roth IRA within 5 years? You could be penalized 10% for an early distribution.
Did you complete your RMD obligation before you convert?
Are there any non-deductible contributions in the IRA you are converting? You could be subject to pro rata rules.
Will the conversion drive up your capital gains rate?
Do you deduct medical expenses?
Will increased taxable income impact your Qualified Business Income Deduction?
Will any state tax benefits be phased out?
Is your income level eligible for the ACA premium tax credit?
What is your state income tax rate? Does it change for retirement distributions?
In summary, a Roth conversion can be a valuable strategy for minimizing your tax burden in retirement and maximizing your retirement savings. However, it's not the right choice for everyone, and there are several factors that we need to consider to determine whether it's the right choice for you. As your financial planner, I can help you navigate these considerations and create a customized retirement plan that aligns with your goals and financial situation. By working together, we can optimize your retirement savings and help you achieve financial security in retirement.
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