Roth Conversions: What You Need to Know
Imagine sinking 30 years of blood, sweat, and tears into building your nest egg. Only to have up to 40% systematically drained away by the IRS in your retirement years. For many Americans, this financial nightmare becomes reality as taxes take huge bites out of savings they were depending on.
But it doesn’t have to be this way.
With the right strategy, you can legally minimize what you owe Uncle Sam and maximize what you get to spend enjoying your hard-earned freedom. The tax code itself provides the blueprint for defending your assets.
By leveraging the power of Roth IRA conversions, you can potentialy unlock hundreds of thousands in tax-free income during retirement. Keeping more of your money working for you rather than the government. The savings can mean affordability of your ideal lifestyle as well as leaving more behind for heirs.
Yet most retirees aren't even aware such options exist...
The key is understanding what Roth conversions entail, how they work, and prudent planning to employ them. So you can confidently claim what is rightfully yours while slashing stress around retirement taxes.
Key Takeaways
- A Roth conversion transfers traditional 401(k) or IRA money you contributed pre-tax into a Roth account to now grow & withdraw tax-free in retirement.
- Pay income taxes when you convert funds but then never pay taxes again on withdrawals after age 59 1/2 or account growth over time.
- Roth conversions provide many benefits but also carry tax implications and considerations you need to model out.
- Work closely with your tax and financial advisors to see if a Roth conversion makes sense and is part of smart broader retirement planning.
- With guidance, Roth conversions allow you to maximize both today's income tax minimization and future tax-free retirement withdrawals from your current savings.
WHAT IS A ROTH CONVERSION?
A Roth conversion refers to the act of transferring funds from a traditional pre-tax retirement account, such as an IRA, into a Roth IRA account.
Traditional retirement accounts are created using pre-tax dollars, meaning the distributions you take from the accounts in retirement are taxed as ordinary income. A Roth IRA is created using after-tax dollars, meaning the distributions you take from a Roth IRA account in retirement are tax-free (because tax has already been paid).
By converting to a Roth, you pay income taxes upfront on the amount converted. But then you get to let your money grow tax-free from that point forward.
THE BENEFITS OF A ROTH CONVERSION
While a Roth conversion is not for everyone, there are some benefits attached to this conversion. Let’s look at some of them below:
1. Watch your money grow tax-free for longer
Once your money is converted into a Roth account, all future investment growth becomes completely tax-free. For funds left over decades to compound, this tax protection provides massive savings compared to a regular taxable investment account.
Over 30 years, an initial $50,000 investment could grow to over $500,000 assuming an 8% average annual return. But if you had to pay taxes on the gains each year, you may end up with only 70-80% of that full amount in a taxable account.
That's tens or even hundreds of thousands of dollars you potentially get to keep by letting it grow tax-free!
2. Avoid Required Minimum Distributions
The IRS requires owners of traditional IRAs and 401(k)s to start taking annual required minimum distributions (RMDs) based on your account value and life expectancy once you reach a specific age based on your year of birth.
This ensures they eventually collect taxes owed on your original pre-tax contributions and all the years of tax-deferred growth. Failure to take RMDs can result in a hefty penalty on the amount you should have withdrawn!
However, Roth accounts don't have RMD rules. You can leave your tax-free money alone to keep growing if you don't currently need the income. This flexibility gives you more control to optimize withdrawals for lower tax brackets.
3. Leave a tax-free inheritance to your heirs
A Roth IRA can be left as an inheritance to your heir(s). The people who inherit your Roth IRA will have to take RMDs, but they won't have to pay any federal income tax on their withdrawals if the account has been open for at least 5 years.
4. A “backdoor” conversion can get you into a Roth IRA—even if your income is too high
A Roth IRA can be obtained even if your income is “too high” by using a 2-step process, often referred to as a "backdoor" strategy. You will first have to place your contribution in a traditional IRA—which has no income limits. Then, move the money into a Roth IRA using a Roth conversion. It is very important to understand the consequences before using this strategy.
ROTH CONVERSION TAX IMPLICATIONS AND RISKS
You'll receive a 1099-R form by January 31st of the following year reporting the amount converted as taxable income.
The total gets added to your other income sources like salaries, interest, dividends, and any retirement account withdrawals.
- For amounts that wouldn't put you in a higher bracket, you simply owe your current marginal tax rate.
- But for larger conversions that bump you into the next bracket, you may owe the higher rate on only the amount above each threshold.
- There are also considerations around phaseouts for certain deductions and credits as income increases.
Reasons Not To Convert to a Roth IRA
While Roth IRA conversions can provide valuable long-term tax savings for many, they aren't right for everyone's financial situation or retirement goals. Here are 4 reasons you may want to think twice before converting:
- You expect your tax rate to be lower in retirement. If your retirement tax rate will fall into a lower bracket than your current rate, you likely want to delay paying taxes on your traditional savings. You would lose out on the upfront tax savings that made contributing to the traditional IRA worthwhile. Modeling out projected required withdrawals and taxes can clarify if this may apply.
- You need the IRA funds soon for income. Withdrawing from a Roth IRA within the first 5 years of the conversion triggers penalties and taxes on the distributions, eliminating conversion benefits. If you expect to rely on those assets before age 59.5 or very soon in retirement, converting may not make financial sense.
- It pushes your tax bracket much higher. Even small Roth conversions could bump your taxable income into much higher marginal tax brackets. Run projections factoring in all your retirement income sources to quantify the true incremental tax impact beforehand.
- You can't cover the tax bill. If you need to tap the converted assets to pay taxes owed on the conversion, you could face hefty early withdrawal penalties that outweigh savings. Make sure you have cash reserves on hand specifically earmarked for covering the conversion tax liability.
The bottom line is financial situations, time horizons, and retirement goals vary. What fits well for someone else's Roth IRA conversion strategy may not make sense for you. Consult fee-only financial planners and tax professionals to analyze your specific scenario before deciding one way or the other.
HOW TO MAKE A ROTH CONVERSION
The IRS offers three possible ways for an individual to convert funds from a traditional IRA into a Roth IRA account. These methods include:
- Rollover - You are given existing traditional IRA funds by the trustee and you put them into a Roth IRA account within 60 days. Any such conversions should be done with due diligence, possibly consulting a financial planner or personal tax professional, as there may be major tax implications if not done appropriately. This is even more important because a Roth conversion completed after Dec. 31, 2017, can no longer be recharacterized—in other words, it can't be reverted to a traditional IRA later.
- Trustee-to-trustee transfer - The institution currently housing your traditional IRA transfers the distribution to a different institution where it'll be held in a Roth IRA.
- Same trustee transfer - The institution currently housing your account transfers your traditional IRA funds into a Roth IRA account at their firm.
ROTH CONVERSION EXAMPLES
Let's walk through a couple simple scenarios to show how a Roth conversion works.
Example 1: Full Roth Conversion
Jasmine, a single 50-year old, has $100,000 sitting in a rollover IRA from an old 401(k). She expects to be in the 22% bracket this year and typically takes the standard deduction.
- If Jasmine converts the full $100,000 to a Roth IRA in one year, she would owe $22,000 in added income taxes ($100k * 22%).
- As long as the extra income keeps her taxable income under $100,525, the 22% bracket cutoff for 2024, she would avoid bumping up into the next 24% bracket.,
- However, the extra income could impact other deductions or credits she qualifies for. So meeting with her CPA to review the impact first is highly recommended.
The benefit is now having that entire $100k balance able to grow and be withdrawn tax-free in retirement. Over 20-30 more years investing, the upfront tax hit now is likely well worth the future savings.
Example 2: Partial Roth Conversion
Susie, age 60, has $500,000 in a traditional IRA and expects to need some retirement income soon. She could:
Convert the full $500k to a Roth IRA immediately. But the high tax bill could require withdrawing extra funds.
Convert $100k per year over 5 years instead. This keeps the tax impact manageable while still getting major assets into the Roth tax-free.
Or, Susie could even choose to only convert up to the top of her current 22% bracket each year. This lets her avoid bumping into the next bracket every year with the conversion income.
Addressing Common Roth Conversion Misconceptions
Given the complex tax implications of Roth conversions, there are also some common myths floating around. Here are a few important realities to keep in mind:
Myth: Roth conversions are only beneficial if tax rates increase in the future.
Reality: While the benefit does increase if future tax rates rise, Roth conversions can still save money even if you remain in the same bracket. Paying taxes at your current rate to then withdraw completely tax-free in retirement generates significant lifetime value.
Myth: Roth IRAs do not have any required minimum distributions (RMDs).
Reality: While original Roth IRA owners are exempt from RMDs, inherited Roth IRAs are subject to RMDs just like traditional IRAs. Make sure to consider RMD impacts for your heirs when assessing Roth conversion decisions.
Myth: Once you do a conversion, you cannot revert it.
Reality: Thanks to the Tax Cuts and Jobs Act, recharacterization of Roth conversions was eliminated after 2017. Once converted, you can no longer reclassify the assets back to a traditional IRA. This makes working through scenarios and impact beforehand more important.
Myth: Roth conversions cannot be done in employer-sponsored plans like 401(k)s.
Reality: Many company retirement plans now offer in-plan conversions from traditional to Roth 401(k) assets. You can convert vested pre-tax money from the same workplace plan just like an IRA without distribution or contribution limits.
Getting clarity on Roth conversion facts vs fiction goes a long way in setting realistic expectations. Make sure to consult qualified financial and tax professionals rather than word-of-mouth assumptions or outdated information.
FREQUENTLY ASKED QUESTIONS
Still have some questions? Here are answers to a few commonly asked questions around Roth conversions:
Can I convert just a portion of funds from my traditional IRA to a Roth IRA?
Yes, absolutely! You can choose to convert your entire IRA or 401(k) balance in one year. But you can also opt to only convert a portion in the current tax year. Over time, you could then do partial annual conversions on more funds every year. Phasing your conversion allows better control minimizing the tax hit each year.
What if I don't have cash on hand to pay the Roth conversion tax bill?
If you are unable to pay the added tax liability from regular non-retirement savings and you are under 59.5 then you should postpone your conversion. The penalties and fees for early 401(k) or IRA withdrawals eliminate any benefit from trying to use those funds directly to pay conversion taxes. Make sure you have cash on hand specifically earmarked for covering the tax bill before initiating any Roth transfers.
If you are over 59.5 years old then a Roth conversion and paying the tax from your retirement account can occasionally make sense. In this case, it is even more important to run models on the potential benefit and think about potential risks.
Can I convert my existing traditional 401(k) to a Roth 401(k)?
If your employer offers a designated Roth account as part of its 401(k) plan, you may be able to convert some or all of your existing traditional 401(k) balance to the Roth side. Any vested money is eligible to transfer without tax penalties, similar to moving funds from a traditional IRA to a Roth IRA. This "in-plan" conversion allows you to keep growing the assets tax-free within the convenience of your workplace retirement account.
PUTTING IT ALL TOGETHER
As you can see, Roth conversions involve both tremendous potential benefits but also lots of details to get right. Make sure to run scenarios reflecting your specific situation before deciding if converting makes sense this year.
The impact on your annual income taxes, future estate plans, and ultimate retirement withdrawals could be significant. Working step-by-step with qualified financial and tax advisors is key to avoid any costly mistakes or assumptions.
But when done prudently, strategically relocating funds from traditional accounts into Roth vehicles sets you up for maximizing resources down the road. Few retirement financial tactics can generate such impressive compounded lifetime value.
Hopefully this guide gave you a helpful overview explaining what Roth conversions entail. Just remember to treat the decision carefully and align conversions as one integrated piece within your overall financial blueprint.
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