What is a Roth Conversion & Should You Be Doing One Right Now?
Today we’re talking about conversions. Not the kind that turns your life around, gives you purpose and a new identity, and enables an eternal relationship with the creator of the universe. That’s the most important conversion in existence. This one doesn’t even compare, but at least it could save you on taxes over the long run. Today we’re talking about Roth conversions.
What is a Roth Conversion?
A Roth conversion is the process of moving money from a pre-tax retirement account to a post-tax retirement account. Now, you might be thinking, “Why would I want to convert my tax-deferred savings into something that’s going to increase my tax bill?” It sounds a little counterintuitive, right? The key is to look at your life-long tax burden rather than just what you’re paying in taxes this year. While it may be hard to get past having a bigger tax bill this year, it can be a really smart move. Just give us a chance to explain.
Traditional vs. Roth Retirement Accounts
Let’s start by reviewing the two types of taxation of retirement accounts.
- Traditional: These are accounts where you put money in before paying taxes. That means the money you contribute reduces your taxable income now. Nevertheless, when you take the money out in retirement with all of its earnings, it all gets taxed as regular income.
- Roth: You contribute money after paying taxes, so it doesn’t reduce your taxable income now. However, when you withdraw the money in retirement, it’s completely tax-free, including all of the earnings.
The key difference is in when you pay taxes—now or later. The Roth offers the benefit of tax-free withdrawals in retirement, but you have to pay taxes upfront.
How Does a Roth Conversion Work?
A Roth conversion allows you to move money from a traditional retirement account (like an IRA or 401(k)) into a Roth account. But, when you convert funds from a traditional account to a Roth account, you pay taxes on the converted amount as if it were ordinary income. In essence, you’re converting your tax-deferred savings into tax-free savings, but you have to pay the tax bill now.
Let’s see how it works in real life:
Suppose you have $50,000 in your Traditional IRA that you want to convert. You move it to your Roth IRA. On your tax return, you will have to add that $50,000 to your taxable income and pay the related income tax. How much you pay depends on your tax bracket. If you’re in the 22% tax bracket, you’d owe $11,000 in taxes.
Why Would You Want to Do a Roth Conversion?
There are several reasons why it might make sense to do Roth conversions. Here are a few key ones:
Tax-Free Growth for Retirement
The money in your Roth account grows tax-free, meaning that when you withdraw it in retirement, you won’t owe any taxes on the earnings. This can be a huge advantage if you have time for your investments to grow significantly.
Lock in a Low Tax Rate
By paying taxes today, you’re essentially locking in your current tax rate. This is especially useful if you are in an unusually low tax bracket, think taxes will go up during your retirement years, or if you anticipate being in a higher tax bracket when you start withdrawing funds.
Avoid Widow Tax
When one spouse passes away and the surviving spouse becomes single, his or her tax rates often increase significantly. Roth conversions allow you to pay taxes while married and in a lower tax bracket.
No Required Minimum Distributions (RMDs)
Traditional accounts require you to start withdrawing money from the account at age 73. Roth accounts, on the other hand, do not have required minimum distributions (RMDs), allowing your money to grow for a longer period. This can be a great strategy for leaving a legacy for your children or grandchildren, as your funds can continue to grow in the account.
Tax-Free Inheritance
When you pass a Roth account on to heirs, they won’t owe taxes on the withdrawals. That can be a huge blessing for your loved ones, especially if they are already in a high tax bracket or receiving income-based benefits.
Retirement Tax Bracket Management
Having a mix of both taxable and tax-free accounts gives you flexibility when it comes to drawing money in retirement. It allows you to control your tax bracket by only withdrawing taxable funds up to a certain point before switching to tax-free funds. Also, if you only have taxable retirement accounts, you might be forced to withdraw at the most inopportune times for tax reasons.
Should You Consider a Roth Conversion?
While a Roth conversion can be a powerful strategy, it’s not the right move for everyone. A Roth conversion often makes the most sense when your current income is lower than what you expect it to be in the future. This could be due to a significant drop in income, a season of unemployment, or dropping out of the workforce for a short time, such as to go back to school or have a baby. For many of our clients, they have several years between when they retire and when they start collecting Social Security benefits that are prime for Roth conversions.
Ideally, you should have enough money in cash to cover the taxes on your Roth conversion so that as much money as possible can continue to grow tax-free. However, there are times when it’s still worthwhile to convert funds and pay the taxes directly from your retirement account.
It’s important to keep an eye on your tax situation when doing a conversion. If you convert a large amount of money, you might find yourself in a higher tax bracket for that year, which could end up costing you more than you anticipated. The conversion amount is treated as income, and thus could impact the taxation of your Social Security benefits, your Medicare premiums, or eligibility for government programs, such as student aid and healthcare subsidies.
How to Determine if You Should Do a Roth Conversion
Roth conversions can be a great tax-saving strategy, but they aren’t one-size-fits-all, so it’s important to proceed with caution. There is a lot of nuance in financial planning and many different factors to consider when executing such an advanced tax strategy. As such, we highly recommend working with a professional if you are interested in doing a Roth conversion.
At Guide Financial Planning, we work with our clients on a regular basis to execute Roth conversions and help our ongoing clients to analyze the opportunity on an annual basis. If you would like a highly-trained partner to join you on your stewardship journey and guide you through strategies like Roth conversions, we are here to help. Schedule a free introductory call today!
About Guide Financial Planning
Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner® and Certified Kingdom Advisor®. He has a passion for helping people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.