What Everybody Needs to Know About Roth Conversions and Retirement Planning
Roth IRA conversions have become more popular for high-income individuals who are on track to have a large portion of their retirement income subject to taxation. This is probably due, at least in part, to the fact that converting money from a traditional IRA to a Roth IRA can be very beneficial for managing taxable income in retirement.
The goal of every Roth conversion strategy is minimizing the impact of taxes while increasing wealth and organizing cash flow at a time when extra income may not be available. However, certain rules must be followed in order for the conversion to be done properly and legally.
This blog answers these questions on Roth Conversions:
- What are the potential benefits of converting to a traditional IRA?
- Why isn’t a Roth conversion a one-size-fits-all solution?
- Are there drawbacks to Roth conversions and Roth IRAs?
- How does the IRS treat traditional IRAs vs Roth IRAs?
- Should you pay conversion taxes out of your IRA?
What Is a Roth Conversion?
The initial goal of a Roth conversion is to convert a traditional individual retirement account (IRA) into a Roth IRA. People generally do this because you can contribute dollars to a Roth IRA after taxes—and then make tax-free withdrawals in retirement. Conversely, contributions to a traditional IRA go in pretax, so you will have to pay taxes on your withdrawals from it.
This is why, in the simplest terms, a Roth IRA is a tax-advantaged IRA (whereas a traditional IRA is tax-deferred). After you reach age 59½—as long as the account has been open for at least five tax years—you can make distributions (withdrawals) without being assessed any taxes on them. Since you have already been assessed on the money as you put it in, provided you follow the rules, you are not liable for additional taxes on whatever you take out (including gains from interest).
A Roth conversion is not a cookie-cutter solution; it merits study before you make the decision to convert to a traditional IRA. For instance, if you are likely to need your money back sooner than five years from now, it might not be a good choice for you.
Is This the Best Time To Convert to a Roth?
To decide if now is the best time to convert your traditional IRA into a Roth IRA, you need to consider two things: your current tax bracket and your tax bracket in retirement If you will be in a higher tax bracket in retirement, maybe due to pension or social security income, it may be beneficial for you to consider a conversion before that kicks in.
Assuming no radical changes in our tax code (and that you will continue with relatively similar income levels throughout your life), it makes sense for someone with lower earnings now to convert as soon as they can. In fact, this can help avoid missing out on potential savings down the road. Again, however, one size does not fit all here.
The biggest potential drawback of a Roth conversion may be creating a larger-than-normal tax bill. For example, imagine that your regular IRA’s current balance is $50,000. Converting that account to a Roth IRA (with an effective taxation rate of 24%) will immediately create $12,000 in tax liability for you. If your potential future tax bill could be lower in the long run, today’s conversion could prove to be a mistake.
Avoid Getting Hasty
Some people are surprised to learn that the tax bill on a Roth conversion has to be paid upfront. You cannot wait until you file your taxes. In fact, payment must be sent as a part of your estimated taxes for the quarter. Failing to do so can incur significant fines from the IRS. This is why the payment should come from another account (e.g., your savings or the proceeds from a mature CD).
The worst possible way to pay might be with money pulled from your IRA, itself. This is like sawing the limb you are sitting on off of a tree trunk: You are disposing of support you will need. In other words, you can seriously reduce the earnings potential of your retirement savings by doing this.
Remember that $50,000 example IRA? If you pay your taxes with the same money, your nest egg could drop to $30,000 (or smaller; permanently). From that moment forward, your earnings will only be based on the new figure ($30,000); not what the $50,000 could have gotten you.
People often underestimate their future income levels and overestimate their future investment returns. This phenomenon is known as “hyperbolic discounting:” Investors tend to overly focus on today's interest rates rather than tomorrow's. Meanwhile, they also tend toward significant optimism when considering how much money they think they will save over long periods of time (when compared to historical averages).
Ready To Know the Financial Possibilities?
None of this is meant to discourage you. At TrustCore Financial Services, we prefer to be upfront about the pros and cons of financial decisions. For those who have the ability to pay taxes today, a Roth conversion can be a solid option for planning your retirement. If you think this could be a good financial step for you (or if you could use a hand understanding it all first), we are happy to help you weigh things out.
As fiduciary advisors, we can help determine what your tax liability could be (and how that may affect your IRA balance over time, as well. We enjoy helping people establish a financial plan based on their unique situations and investment management goals. Our clients may tell you that we are the best certified financial planner Brentwood, TN has available. Schedule a complimentary meeting today.
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