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Back to the Basics: Roth Conversions

Most working Americans know the importance of saving for retirement. We are taught that a penny saved is a dollar earned and that delayed gratification is important for long-term financial success. Many people also know of two of the most common retirement account types: Traditional IRAs and Roth IRAs. The key difference between these two types of retirement accounts is when income tax is paid on the money.

In a traditional IRA, contributions to the account are deducted from income in the year the contribution is made, as long as you qualify for the deduction limits. These contributions lower taxable income immediately, and income tax will be paid on the money when it is taken from the account in retirement.

In a Roth IRA, the contributions to the account are not tax deductible (meaning there is no immediate tax savings), but the money that is contributed to the account grows and is distributed tax-free. Due to income limits on Roth IRA contributions, some individuals are unable to directly build up Roth IRA assets; however, there are financial planning strategies that allow individuals to bypass these limits and build up Roth assets, such as Roth IRA Conversions (Roth Conversions). A Roth Conversion allows all individuals, regardless of income level, to move IRA and eligible employer-sponsored plan assets into a Roth account, allowing for tax-free withdrawals later in retirement.

Benefits of Roth Assets

There are numerous benefits involved with having Roth assets in retirement. The most obvious is withdrawals from Roth IRAs are tax-free. Additionally, Roth assets are not subject to required minimum distributions at age 73 like a traditional IRA. If the money isn’t needed for income at that age, it can be left in the account to continue growing tax-free. The tax-free nature of Roth accounts also makes them attractive to the beneficiaries of the accounts. When heirs inherit Roth assets, they do not pay tax on withdrawals from their inherited Roth-IRAs, since the tax was covered at the time of original deposit. With all these advantages, it can make a lot of sense to build up Roth assets when possible; however, when converting assets to Roth, it is important to consider your current and future tax bracket, as well as the rules around Roth conversions and Roth assets in general.

Rules for Roth Conversions

The most important rule to keep in mind for a Roth conversion is that federal and state income taxes must be paid on any portion of the conversion that has not already been taxed. This includes all funds coming from traditional IRAs, which is the normal funding source for Roth conversions. If you already have earned income, Roth conversions could push you into higher tax brackets. Roth conversions must take place on or before December 31st of the year of the conversion, and individuals have until the tax-filing deadline to pay taxes on the conversion.

It’s also important to consider how you’ll pay the tax at the time of the conversion. It is generally best to have cash on hand to pay the tax instead of withholding taxes from the conversion amount, especially if you are below age 59 ½. If someone younger than 59 1/2 withholds taxes on a Roth Conversion, the money that is withheld is never converted, and the withheld amount is considered a distribution. With a distribution at that age, those funds are subject not only to income taxes, but also a 10% penalty.

Another rule to consider is the five-year rule. There is a five-year holding period on Roth Conversion amounts, and withdrawals taken prior to this period ending may be subject to taxes and penalties. If the funds may be needed for upcoming expenses, it may not make sense to convert them to Roth. Lastly, Roth conversions are irreversible. Once the conversion has taken place, you’re stuck with the associated tax bill. Even with these rules to consider, there are several situations where it makes sense to execute a Roth conversion.

Case Studies

A Roth conversion makes the most sense when an individual expects their tax bracket to be higher in future years. Nobody knows exactly what tax rates will look like in the future, but if you expect that your income tax bracket will raise or that tax rates will increase, it may be beneficial to do a full or partial conversion now. For example, imagine Elizabeth, who has just retired at age 60. She is a single tax filer, and has a traditional IRA, an individual brokerage account, and cash. Elizabeth has $1,500,000 in her taxable brokerage account and $500,000 in cash, which gives her the flexibility to keep her taxable income low. Between all income sources, Elizabeth expects to only have $25,000 in taxable income until age 73, when RMDs will begin from her IRA. Each year until age 73, Elizabeth could convert just under $20,000 per year to a Roth IRA without leaving the 12% tax bracket, which would leave her with just above $157,000 (without investment growth) in a Roth IRA that isn’t subject to RMDs or taxes upon withdrawal, as the taxes have already been paid in the 12% tax bracket.

Take the same scenario above but assume that Elizabeth has deferred compensation from her previous employer of $100,000 per year from ages 65-73. In this scenario, if she were to convert the same amount to a Roth IRA each year, she would pay taxes in the 24% tax bracket. While this still may still make sense for Elizabeth depending on her overall financial picture, it is not as easy of a decision and would have to be evaluated in conjunction with her individual situation and long-term financial plan.

Guiding you Forward

At Pathfinder Wealth Consulting, decisions like utilizing Roth Conversions are always done with consideration to each individual or family’s unique circumstances. Our team of CERTIFIED FINANCIAL PLANNER ™ professionals work in conjunction with your tax professional to ensure every party involved in your financial wellbeing is on the same page when it comes to recommendations and strategy implementation. We believe that individual recommendations must align with your unique long term financial plan, based on your goals, and that tying everything back to the plan helps provide a clear path that you can follow with confidence. If you would like to learn more about aligning your financial plan with your retirement goals, give us a call at 910-793-0616 (Wilmington) or 919-463-0018 (Cary). We are here to guide you forward.

*Case studies are for illustrative purposes and should not be construed as a recommendation. It may not be representative of your experience.